It's Not Time to Sell

Check out this graph of the historical Price/Earnings ratios for the S&P500 Index. I especially like it because it visualizes the old saying "buy low, sell high" and because it is screaming to everyone, "buy right now, and don't you dare sell after the horrendous January we've been having!" Click to enlarge:

The Red line is the historical Price/Earnings ratio of the S&P500 (it's the weighted average of the P/E ratios of the individual constituents in the S&P500 index). The Blue line shows how much the S&P500 index was up or down (in percentage) exactly 12 months after the Price/Earnings observation.

The black trend line in the middle is for the P/E ratio (not the percentage gain), and it gives fairly reliable buy and sell signals. When the P/E ratio is below the trend line, stocks are cheap and it's time to buy. When the P/E ratio is above the trend line, stocks are expensive and it's time to sell. For example, P/E ratios were clearly above the trend line during the late 1990's and early 2000's (indicating a time to sell). Anyone who paid attention to this graph could have avoided some fairly painful losses caused by the bursting Tech Bubble.

Obviously, this graph is not perfectly correct all of the time, and looking back over the last 35+ years there are some exceptions to the rule. However, for the most part, things have worked out fairly well. Also, I've run a linear regression of P/E ratios on the S&P500 a couple times in the past, and the P/E ratios do have statistically significant predictive power on the S&P500.

More importantly, the current S&P500 P/E ratio of around 16.4 is clearly below the trend line, indicating now is NOT the time to sell. This, despite the abysmal month of January and the high levels of fear in the market.

Comments

[robster]

a valid point but you can't take it in isolation. We have a very different animal on our hand with a potential 1.5% decrease in rates in one week and financial bombs all over the place. In theory your point is well placed but cheap isn't always good.

[CloroxCowboy]

There does seem to be a decent correlation there, but I also have to admit that the situation feels different this time. Of course, people said that the ridiculous dot-com era valuations were not so ridiculous because "the nature of business" had somehow changed and earnings didn't matter anymore...I'm excited to see which way this one plays out.

I feel like there's just too much bad sentiment after such a long bull market for prices not to decline significantly. Also, most of the bullish commentary, other than this article which makes a factual observation, seems to have a pleading, praying, less-than-rational undertone. Makes me think plenty of people bought at the top and want things to recover to save their own egos.