By Ric Spooner, Chief Market Analyst, CMC Markets Australia
US stock values became pretty expensive over the 2 final months of 2015. Given the US market’s role as a global sentiment leader, this had become a burden for global equities. In the current sell-off, this high valuation risk is now rapidly unwinding. If the wheels don’t fall off in China, I don’t think we will have to wait too long before bargain hunters start getting pretty attracted to US stocks.
Downward momentum is strong at the moment and it’s always possible that China could provide real reasons for concern. Trying to catch falling knives does not look the way to go right now.
But if the market does drop another few percent on sentiment and without hard evidence of new problems in China or emerging markets, some trades may start to find stocks more attractive.
US Stock Values - S&P 500 price earnings ratio
The chart below shows forward PE values for the S&P 500. PE values are a blunt and imperfect tool but they can be a useful way of getting an alternative view of just how “cheap or expensive” an index is at different times.
Over the past 25 years the S&P 500 has averaged 15.8 times forward earnings. Over the past 2 years it’s averaged about 16.8 times. The higher average valuations over the past 2 years reflect low interest rates.
The S&P’s forward PE peaked in April last year at 18 times. It got pretty high again during November and December. The recent Santa rally peaked at 17.6 times.
The latest sell off has seen valuations fall to 16 times. A 38.2% Fibonacci retracement of the whole post GFC recovery in stock values would see the forward PE down to about 15.4 times. There is also a BC = XA x 127% Fibonacci projection at this level on the PE chart. Having both these Fibonacci projections at the same level increases the potential significance of the 15.4 level. It’s also below the long run average
US SPX 500 price chart
price chart has just hit a potential trend line and AB=CD level at 1970. But downward momentum is high so there’s a big risk price could drop straight through this.
There’s another Fibonacci cluster around the 61.8% retracement at 1940. Rejection of this could set up a bounce. However, tying the PE chart in with the price chart makes the 78.6% retracement, just below 1900 the most interesting to me at this stage. That would see the PE values back around 15.4. .
The 78.6% level on the daily chart would also pick up long term trend line support shown on the weekly chart below.
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