In the following chart, we look at the median price to earnings ratio (PE) to get a sense of current valuation. Are U.S. equities, in general, inexpensively priced or expensively priced? If we buy an inexpensively priced asset, there is greater future return potential. Stating the obvious, if we pay too much, our return potential is more limited. Not a problem if you have a 20-30 year time horizon and the ability to stay the course when turbulence hits (2002, 2008, etc.). It is a problem when a major correction occurs just prior to your retirement.
There are many ways to measure valuation. I favor median PE for it is a mathematical process based on ACTUAL earnings. History has shown that Wall Street analysts tend to over-estimate future earnings. The challenge for those who favor forward earnings estimates to calculate PE is that there is a long pattern of those estimates subsequently being revised lower. Thus, this is too much of a moving mark for me.
Median PE gives us a very good picture of current market valuation and helps frame short-term to intermediate-term upside and downside price targets vs. historical levels. This understanding can prove valuable in the management of your money. For example, one might wish to hedge downside risk when prices become richly priced. The reverse is true when valuations are attractive.
Here is how to read the chart. The current Median PE is 20.5 (data through 2-28-14). The 50 year median PE is 16.7. If you take the most recent reported earnings (median calculation) and times it by the 50 year average PE of 16.7, you get a suggested fair value of 1517.53. A 1 standard deviation move above 16.7 suggests the market is overbought at 1987.32. This is approximately 18.4% below the current levels.
The probabilities to me suggest an upside target of 1987 for the S&P 500 Index with a fair value at 1517. Given the current support of the Fed (as in don’t fight the Fed), the downside or undervalued target of 1047.75 is far less probable.
The problem that I see today is that sentiment is very bullish and the crowd is generally wrong at points of optimistic extreme. Thus, my belief that some proactive form of risk management (hedging) makes sense as it relates to your important long-term equity portfolio positions. – Steve Blumenthal