The Stock Market Drop – S&P P/E Ratio

Posted by cameron

July 29, 2007 |

The news has been full of the stock market drop this past week and billions of dollars was withdrawn from mutual funds on Thursday and Friday. Buyers moved to the sidelines leaving only sellers to move markets. When that happens the only way is down. Having scanned the Internet sites for professional opinions you can find whatever you want to hear. Everyone has an opinion on the cause and what is yet to come. Sure, many have decades of experience but I wanted more facts and less opinion. I decided to check out the S&P P/E Ratio over the past five years; to look at previous corrections and near corrections. It is dangerous to extrapolate the past to the future but there are some interesting facts to share. In the last paragraph below I explain how to get this information.

Five years ago, when the current bull market started, the P/E ration was around 35. That is high by historical standards but it didn’t stop the bulls. Since that time the S&P 500 has gone from less than a 1000 to over 1500. I know it ended last week at 1452 but it has still been a great run. Everyone has gained very nicely. What is less known is that the market P/E Ratio has actually fallen over that same 5 years to under 18; almost half of what it was at the beginning. Normally I would expect the opposite. To me this means that earnings per share have risen faster than price per share and the stock market is a better value today than at almost any other time over the past 5 years. Last years correction (not an official correction but close enough) at its worst took the P/E ratio below 18 but not below 17. We are not far from that same position today.

Since the market looks at the future not the past, are we going further down? Well that depends on emotions but what we do know is this: The US economy picked up in the second quarter and the World Bank raised its forecast for the global economy in 2007. Not the kind of announcements one would expect if we were entering an extended bear market.

My take is this; no one can say what will happen in the coming weeks and months but if it is an official correction then we have another 4 or 5 percent further down to go, at which time the market will have the lowest P/E ratio it has had in the past 5 years. If the past 5 years are anything to go by then I can hardly wait for the next five. Corrections are buying opportunities or a time to do nothing. The worst things to do are panic and sell at the bottom. We seem to get a correction every year or so and this year will be no different. After every correction there has been a surge to new highs. Hang tough.

To get the information above go to CNN Money’s advanced charts and set the time-line to 5 years, set the Index to S&P 500 and the “lower indicators” to “P/E Ratio. (These are drop down box choices on the left hand side.) Press the button, which says, “Create chart”, below those drop down boxes. The display shows the S&P in the top frame and its P/E Ratio over the same time frame in the lower chart frame. You can change the time-line to less than 5 years to get a closer look at most recent corrections.

Comments

2 Comments so far

Marye on July 30, 2007 11:01 am
I am wondering though, if some of it isnt a reflection of the trend of babyboomers retiring and withdrawing funds? If so it has a long way to go before it stabilizes.
I am watching carefully.
Cameron on July 30, 2007 5:29 pm
Thanks for stopping by Marye. I definitely think that trend is beginning but its just in its infancy. There will be an impact.