It is important to put large gains or declines in perspective to better understand what is happening.
One of the best gauges to use is how expensive or cheap the overall stock market is at that moment.
For that, we turn to the price earnings ratio for the Standard & Poors 500 Index.
The Stock MarketWe use the S&P 500 because most investment professionals consider it “the market.”
The Dow (Dow Jones Industrial Average) is more volatile because it represents only 30 stocks. You will always see bigger swings in it than you will in the S&P 500.
The PE for the S&P 500 is a simple average of all the PEs for the 500 stocks in the index.
You’ll remember that PE express investors’ confidence in future earnings. A high PE means investors have high hopes for future earnings.
It can also mean investor hopes are not supported by current earnings. In other words, the price has increased dramatically, but there is no corresponding rise in earnings.
A sky-high P/E means traders have gained control of short-term prices.
A low PE may mean investors have lost confidence in a company’s ability to produce consistent future earnings. For a review on PEs, check out this article.
High PEWhen the PE for the S&P 500 is high, many would say the market is overpriced – that is investors are paying too much for stocks (investors’ perception of future earnings in addition to current valuations).
For example, at the end of the previous bull market, the PE for the S&P 500 was almost two and one-half times recent levels. Yet in the 2008-09 period the S&P 500 has nosed dived, then shot up.
Many events cause the market to move up or down from day to day. However, if the market is “over-bought,” you can expect greater volatility and the odds of a major sell-off or correction are higher.
Bull Stock MarketA high PE for the S&P 500 is not an indicator of a bull market, but may show up when investor enthusiasm over-reaches reality.
Unrealistic expectations of continued high performance have a way of being dashed, which is what happened when the dot.com bubble burst in 2001.
When you see huge numbers like those in the listing above, you have to ask if something is going on to produce these results.
When a market index or individual stock shows a dramatic price gain without a corresponding increase in earnings, you get a very high P/E.
A sell-off when the S&P 500 PE is in a moderate range may mean nothing more than a reaction to current events and not the beginning of a protracted down market.
That’s not written in stone, but it makes sense that sell-offs when the S&P 500 PE is unusually high can be like air venting out of an over-inflated balloon.
The stock market is a dynamic and complex environment. Simple answers are seldom complete answers, so when trying to make sense of what is happening consider the PE of the market as one factor in your investigation.
You can find recent and historical PEs for the S&P by following this link.