Oh, gosh. Now people are afraid of the stock market because of the U.S. debt issue. Republicans vs. Democrats. If the U.S. loses its AAA rating, what will that do to the stock market?
Profits are Strong, For the Market to Fall, the P/E has to Fall
Earnings (profits or EPS) are good this year. Companies are growing. Profits are up. The S&P500 (the market) is expected to make $96 this year, up from $85 last year.
So for the market to fall while the earnings are rising then that means the mareket’s P/E ratio has to fall:
EPS x P/E = Price
So if EPS is expected to rise from $85 to $96 this year. For the market (Price) to fall, then the P/E has to come down.
A Look Back at Other Market Highs, Lows
In 1999, around market highs, the market’s P/E (S&P 500) finished the year at 28.
The market then fell and the P/E got to 19 in 2002, before the market took off in March 2003.
In 2007 the market’s P/E was 18 at the end of the year.
By the end of 2008 (after the carnage of the financial crisis) the P/E was 14.
Right now the market’s P/E is around 14. Looking at recent history, that seems low. So are we to think this is the market high? I don’t think so.
How Low Could We Go?
Profits are growing and the P/E is already low. How low could the market go?
The last time we ended the year with a lower P/E than 14 was 1998, when it was 12. That’s 23 years ago.
If profits come in as expected this year, and we get that 12 P/E. that would mean a 14% decline in the market. On the other hand, the highest P/E was 30 in 2001. The math shows we are closer to the bottom than the top.
Let’s illustrate (each dash =1):
12- 14- – – – – – – – – – – – – – – 30
Bottom Line
Earnings season has been going on all month. Most companies are coming in with great news and profits. The bad news is political. Stay out of it. Stay in the market.
