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The S&P 500 Needs to Fall Another 50% Before Stocks are Cheap

|Includes: SPDR S&P 500 Trust ETF (SPY)

With the words “green shoots” and “bull market” getting more and more coverage in the mainstream financial press, it’s worth considering if this current market/ economy is actually improving. Personally I don’t know what data the folks at CNBC are looking at. Because to me, all signs point to further wealth destruction and great economic contraction to come in the months ahead.

For starters, there’s the issue of sentiment. Many commentators have made a big deal out of the fact the Chicago Board of Options Volatility index (VIX)- a common measure of investor sentiment- recently fell below 30 for the first time since the Market Crash in October. However, a VIX reading of 30 only indicates that investors are back to normal “bear market” freak out mode as opposed to full-blown “the world is ending” crisis hysteria: remember the VIX was at 30 during the recession of 1990-91 and during the Tech crash. So this hardly indicates things are getting much better.

Moreover, from a valuation perspective, stocks are nowhere near cheap. During the recessions of the early ’70s and ‘80s, stocks fell to trade at single digit Price-to-Earnings (P/E) ratios. With this current recession obliterating earnings every month, P/E ratios are actually rising, NOT falling.

Consider that earnings estimates for the S&P 500 in 2009 currently stand at $28.51. With the S&P 500 trading at 887, this puts the stock index at a P/E of 31! That’s the kind of valuation seen during bubbles, NOT bear markets.

For the S&P 500 to trade at a P/E of 7 (where it did during the last two major bear markets), the S&P 500 would have to fall to 200 (I’m not saying this will happen, but simply pointing out how expensive stocks are). Even a P/E of 15 would put the S&P 500 at 382: a more than 50% decline from where the market trades today.

Of course, this is assuming that the current earnings estimates are accurate: as recently as Feb 9, 2009, earnings estimates for the S&P 500 in 2009 were as high as $42. It’s also worth mentioning that earnings are generally massaged to be higher than real profits via various accounting gimmicks. REAL corporate profits (cash flows) are likely to be even lower.

No, if this bear market goes the way of others, we’ve still got quite a ways to fall. Indeed, as far as bear markets go, we’re currently right in the middle based on the number of weeks declining: 

Bottomline: Don’t trust the mainstream financial commentators or government officials. We may be seeing “green shoots,” but remember that green shoots can spring up even in a barren parking lot. This doesn’t mean you’ve got the makings of sustained growth.

Instead, it’s far more likely that this market has a long ways to fall. We’re certainly long overdue for a correction of 10% or so. I wouldn’t be surprised if we got this in the next four weeks.

Prepare your portfolio accordingly.

Good Investing!

Graham Summers 

ps I've put together a FREE Special Report on how to profit from the coming Market Collapse. It's called the Financial Crisis Round Two Survival Guide and it's available FREE at Swing by and pick up your copy  today!