The S&P 500 is widely considered to be the benchmark of world financial markets – the main large cap index of the world's largest economy and stock market. The valuation calculations below are, therefore, mainly related to this index. There are three main factors involved in determining the return on equity market investments: 1) Interest rates. The lower rates go and the longer they remain low, the more risk taking on the market is understandable. If rates rise, an adjustment is usually made by stock prices generally falling. By now, you know interest rates in most major countries are very low or negative and can probably only reverse from here. This would be negative for indices. Despite this, the market continues to go up. 2) Changes in corporate profitability. The more traders expect higher results for the coming quarters, the more they tend to be open to go long even in case of "potential overvaluation". In this regard, earnings expectations were particularly high in late 2014 for Europe and the US, but levelled off in recent months. Yet prices continue to rise... It seems that a difference has formed between the estimates of earnings per share and index prices. This phenomenon could be explained by "wishful thinking" currently up in the media. Wishful thinking is the decision by traders to act on what "might" be pleasant to imagine rather than to give importance to the evidence, rationality or reality. Some psychologists believe that having an optimistic attitude and thoughts allows for best results – this phenomenon is called the "Pygmalion" effect. The problem here is that many optimists are equity managers, who hope that shares will go up regardless of business results. 3) Market valuation: If the market is considered too expensive, the future return on investment would be low and traders would stay away from equities. Conversely, if the valuation is too low, stocks could attract more investors. Are we currently over- or under-valued? Let's try to answer by studying several ratios. Why is the price-earnings ratio an outdated indicator? The PE ratio uses the SP500 ratio, rolling 12 months compared to business results. The problem is that it is quickly undermined in periods of strong economic expansion or in case of severe recession. Thus, when we study the P/E for the SP500 in the first quarter 2009, it was 123, a historical record and yet the market realised a low point ... this indicator is not optimal. Nevertheless, note that it is now close to its historic high zone of 100 years, but not as extreme as in 2000 or 2008. The Shiller P / E gives a better indication of timing Professor Robert Shiller of Yale University invented this ratio to refine the market’s valuation assessment. This indicator is considered to be more accurate as it eliminates fluctuations due to wide variations depending on profit cycles. On the chart above you can see the high points of the indicator in 1929, 2000 and even 2008, below the threshold of 27 – where we are currently. Some may say that we are not at 2000 levels. I would, say that we did not need hyper assessed markets sufficiently overvalued for a correction to take shape. The ratio of total market capitalisation of US GDP is, according to Warren Buffet, one of the most relevant. By studying it we can see that we are not far from record levels. Finally a comparison and not a ratio: the total capitalisation of the US market represented by the Wilshire 5000 (5000 most traded shares) with the US GDP. Far be it from me to conclude anything with this comparison, simply note that a reversion to the mean could be legitimate. Finally, historical analysis suggests in the past it has been more attractive to go long stock markets when the total capitalisation of Wilshire is less than the US GDP rather than the reverse. In other words, while the S&P 500 has reached record highs recently after having completed a historic rally, it should be borne in mind that stock prices do not appear to be undervalued. Currently, they look at best fairly valued in relation to future earnings estimates and at worst overvalued but are helped by the rhetoric of central banks that have been artificially supporting markets in recent years. Graphically, the S&P 500 has recently reached a major expansion of Fibonacci: 161.8% to 2130 points. You can note how the momentum capped as in the two previous corrections, but I'll let you do your own review in light of what you just read about the logical potential sequence of events. CMC Markets is an execution only service provider. The material (whether or not it states any opinions) is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by CMC Markets or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.
Read all of our Q3 articles:
Neutral outlook for sterling as UK growth evens off Cooling China brings ANZ back to the pack Q3 market outlook: sector performance and earnings season preview European economy faces significant headwinds Bonds: all traders should be watching bond charts What does the OPEC meeting mean for oil prices? Chinese equities: Will it all end in tears? The Japanese stock market could continue to rise in the coming months Q3 market outlook: a swing trading summer looming for US markets?
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