GuidoWorld

Bride of FrankenMarket

May 6, 2009 on 7:12 pm | In General |

In February I wrote a series of posts regarding  the stock market saying that the Dow had to get above 8400 and stay there or it was going to roll over. Well, it did roll over. At that time I mentioned that I had expected more out of the rally out of the fall low.

Well were back at it again.

After the low on March 6 we have seen the type of rally I had expected earlier in the year.  The Nasdaq is up some 40%  in just two months. The S&P and the Dow could get there this week.

Does this mean the bear market is over and a new bull is here?

From a historical perspective this seems very unlikely. In fact during the last depression we had a number of these breathtaking rallies which sucked everyone back in only to have their hearts and bank accounts broken.

How much further will this rally go? Well it could stop at any moment, but could take the Dow all the way up to 9000 or even 9500.

Yet, this rally seems less impressive when you realize that in early February I was talking of the Dow needing to get and stay above 8400 and today some three months later we’re celebrating the largest rally since 1932 when the Dow is a little more than 1% above that same 8400 mark.

Today I’d like to point out one statistical measure that would seem to have us be extremely sceptical of any talk that the economic and market downturn are over.

The Price to Earning Ratio (PE) is often used to help assess the relative worth of a stock. The PE ratio is determined by dividing the price of a stock by the earnings of the company.

As an example if a stock closes at $50 and the company’s current earnings are $5 per share than that stock is selling at 10 times earnings.

Now, expected PE ratios differ from company to company for a variety of reasons such as the kind of business  it is or if it is a new company or part of a new industry. Yet, the Dow and S&P as indexes have historically averaged around 12 to 14 times earnings. When the companies of the these indexes fall below 10 times earnings the stock in these companies is generally considered to be under valued, when above 15 times earnings the stock is often regarded as over valued.

When the PE of the entire Dow or S&P is over 20 we are said to be in a bubble.

Seldom does an index PE ratio rise much above 24 times earnings. Historically, every time this has happened the market has entered a bear market which has continued until the index’s P/E  has gone into undervalued territory.

Bear markets continue until PE’s get down to about six or seven.

When this bear market started the Dow and S&P were in historically high PE ratio territory. Some estimates has the Dow’s PE over 40.

While the bear cut the Dow from 14400 to 6400 in a savage fall in a little over a years time, the PE ratio tumbled. As stock prices fell so did the earnings of  the companies, so that while the Dow lost over 50% of  its value, its PE ratios still stayed in overvalued  territory.

In fact the Dow and S&P never even got below bubble territory as the PE’s of the indexes remained above 20.

With this current rally the PE’s are currently up in nose bleed territory. The Dow’s PE is currently over 33 and the S&P is over 50.

In previous bear markets following bubble markets the bear market does not end until the PE of the Dow gets under 7. In order for this bear market to follow the historic norm the Dow would have to fall to somewhere between 1600 and 2000.

Am I predicting this. No, not really.

But, I do feel pretty safe in saying that we are going to be a lot closer to 2000 than 1000 before this bear market is over.

Not once has a bear market following a bubble market ended with the PE of the Dow staying above 10.

Now, earnings could improve some while the bear is doing its job, especially if we get an inflationary environment rather than a deflationary one.

So, just maybe we’ll be able to get the PE ratio below ten and keep the Dow from bottoming out below 3000.

It could happen, but I wouldn’t count on it.

Yet, to think the worst is over when PE’s are still in bubble territory is fool hearty at best, and just goes to show how far we still have to go.

When most bear markets end the average person hates and is out of the stock market. At the end of bear markets interest in and participation in the market is at a low.

We’re not any where near that happening yet. People are still trying to make the money back they lost last year in the market, and that is the mixture of hope and desperation that bear markets feed themselves on.

Yet, if this time were going to be different our PE ratios would not be in nose bleed territory.

Please be careful and heed the warnings of history.

Jim Guido