S&P 500: Caveat emptor!

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The S&P 500 Index is entering expensive territory with the cyclically adjusted price-earnings ratio at 22.64 approaching the average of 25.0 from the post ICT crisis to the advent of the Lehman debacle. The current level is also at the upper end of the range that existed from 1881 to the start of the ICT bubble in the latter part of the 1990s.

On the normal basis, with the PE calculated trailing 12-month earnings, the market is inexpensive at 17.86 times earnings compared to the past 20 years. However, the market is expensive compared to the long-term historical average of 15.5 times earnings.

The Q Ratio defined by Doug Short as the total price of the market divided by the replacement cost of all its companies is currently at the upper end of the range since 2003 and near the previous peaks in valuation since 1900 bar the ICT bubble in the latter part of the 1990s.

Source: dshort.com

Sitting on a price to book value of 2.3 times the S&P 500 is still significantly below the average of 2.9 times since 1981. Barring the ICT bubble the average is closer to 2.5, though.

Sources: Various internet; Plexus Asset Management.

If the S&P 500’s long-term historical earnings growth of 6% in real terms is factored in and given the average dividend yield of 3.7% of the S&P 500 over the past 70 years, the capital return over the next seven years is expected to be minus 1.1% per year. If the exit dividend yield turns out to be that of the past ten years’ average of 2.1%, though, the capital return will be 6.1% per year.

Sources: Hussman Funds; Plexus Asset Management.

In light of the extended valuation levels I think the market is currently discounting the latter and view it as close to the upper limit of what can be expected. I will treat any further significant strength in the market with the utmost caution.

At best, it seems to me that year-on-year growth in the coming years could range between 0% and 10%.

The declining trend of the peaks in the Coppock indicator of the S&P 500 is also worrisome, indicating that further significant upward momentum will be a hard-fought battle and not without risk.

The technical position is also telling me that a significant correction may be in the offing.

Caveat emptor!

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More on this topic (What's this?)
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S&P Approaches Critical Tipping Point
Read more on S&P 500 (SPX) at Wikinvest
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