Monday, August 24, 2009

Price to Earnings

The P/E of a stock is a ratio used to determine how expensive a stock is, and it is formulated by dividing the price of a stock by the earnings of the company.

If a P/E ratio is high the stock is considered expensive. If it is low it is considered a bargain. Historically when stocks were in the 7-10 range they have been considered cheap and that point usually marked the end of a bear market cycle.

On the other hand, during the absolute mania stage of the stock market bubble in March of 2000, the P/E ratio reached 52. This was the highest on record and marked a point of lunacy for new buyers purchasing shares.

During the stock market collapse from October 2008 - March 2009, the P/E ratio bottomed out at around 18. This was still considered expensive in historical terms. Since that bottom in the S&P 500 of 666 on March 6th, the market has rallied about 50% and has rocketed straight upward without a pull back. The following chart shows stocks current P/E ratio with this most recent move:




We are currently sitting at a P/E ratio of 129.

This has occurred because company earnings have collapsed across the board at a time when stock prices are exploding upward. (Become more expensive)

Can the P/E ratio go higher from here? Absolutely, and it probably will. Would I bet my money on it? No thank you. I'd rather play Russian Roulette.

While the P/E ratio is a gauge of market fundamentals, the daily sentiment index is a gauge of where the market may be heading from a technical perspective.

The following is a chart of the S&P 500 from October of 2007 through today. The important line is the one below the index which shows the sentiment of traders over the past two years. At the market's all time high the sentiment index touched 88%. This means that at that point 88% of market participants thought the market was going higher: they were bullish.
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This afternoon that index crossed 89%, the extreme reached during the October 2007 high. Technical traders use these tools to determine points when the market is most vulnerable for a turn.

(To understand why think about this example: If 90% of the market is bullish then they have already invested their capital in stocks. They now have no capital to push the market higher because they have already invested it. The short sellers at this point can push the market downward against little resistance from upside pressure.)

As discussed above, this does not mean the market has reached a top. The sentiment index can reach 99% bulls and push the market even higher. (A 99% bullish sentiment level was reached last October in the bond market during the rush to safety in treasury bonds)

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