Why We Are Nervous About The S&P 500 And Overseas Markets

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This isn’t a discussion around the quality of the underlying companies, their ability to make profits or the strength of their balance sheet. This is a discussion of how far can you stretch the rubber band before it breaks and snaps back to bite your hand for being too greedy and looking for that extra inch.

The reality is the S&P 500 (and broadly global indices) have performed well. Fuelled by the easy cash being thrown from so many Central Banks helicopters we’ve seen the S&P 500 hit new highs. What’s missing is the fact that sales of the underlying companies haven’t followed suit.

The S&P 500 Aggregate Price/Earnings Ratio

The P/E ratio of the S&P 500 companies is at 26. It spiked higher than that only three times over the last 136 years: in 1929, it peaked at 30; in March 2000, it spiked at 44; and just before the Financial Crisis, it peaked at 27. The thing to understand is that the aggregate P/E ratio didn’t plateau or level off after these three spikes. It plunged (chart via CPC):

SP 1

If the P/E of the S&P 500 were to revert to a sustainable historical average of 16, the S&P index would fall by 36% to 1,362. And while that’s a usable projection, in reality when corrections occur, the P/E ratio falls below the average for a time, i.e., a correction to 1,362 might be a best-case scenario for the S&P 500.

There is no reason to expect to expect a crash tomorrow. The market could go to its March 2000 levels (which is a 53% rise from here) although we expect that to be unlikely. What we do think this tells us is that there are times to take profits and start reducing our exposure and it appears as though one is forming.

We stress, we aren’t yet even at 2007 levels but it’s good to be aware. Supporting our view is the Price/Sales Ratio.

The Price/Sales Ratio

If the P/E of the S&P 500 were to revert to a sustainable historical average of 16, the S&P index would fall by 36% to 1,362. And while that’s a usable projection, in reality when corrections occur, the P/E ratio falls below the average for a time, i.e., a correction to 1,362 might be a best-case scenario for the S&P 500.

There is no reason to expect to expect a crash tomorrow. The market could go to its March 2000 levels (which is a 53% rise from here) although we expect that to be unlikely. What we do think this tells us is that there are times to take profits and start reducing our exposure and it appears as though one is forming.

We stress, we aren’t yet even at 2007 levels but it’s good to be aware. Supporting our view is the Price/Sales Ratio.

SP 2

What this ignores is profitability. If your profit margins can increase by more than the decline in sales profitability should be maintained and share prices justified. So in itself, this chart isn’t alarming but it tells you we need to look closer.

Ultimately, there seems to be a big appetite for risk at a time when we need to be cautious. Pricing multiples for many investments are becoming stretched and profit taking will help reduce the risk in your portfolio.

What about the ASX?

SP 3

It’s at a 7 year high and above its long-term average too.

This is a general advice and not personal advice. It doesn’t take into account your personal circumstances or risk profile. We recommend discussing with your financial adviser or investment adviser before taking any action.

By: Nick Rundle

Email: nmr@accession3.com

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