S&P 500 Index P/E Ratio

The current sell-off over the past several weeks in US stocks has reached the point at which smart money investors are starting to see value appear. This is by itself no guarantee that further lows will not be reached, but it suggests that we have entered the part of the selling in which an increasing proportion of sales are involuntary liquidations (driven by mutual fund redemptions, margin calls, or a need to cut risk exposure). Of course this is the major reason that the maximum pace of price decline typically takes place right at the end of a correction, which we saw at the beginning of this week.

Below is a chart of the S&P 500 index showing index price (white line), current P/E (green, right side) and Bloomberg Estimated P/E (red, right side). While the price level of the index is no lower than it was for much of Q4 2009, the significant recovery in both the level of US corporate earnings means that the index is trading at an estimated P/E of just under 13. To put this in perspective, the 13 level was only breached during the period of October 2008 to March 2009. Furthermore, during that period of crisis, estimated earnings were being cut at a rapid pace, making a low estimated P/E a much less reliable guide that value was being established than at the current time.

If we couple this P/E ratio decline with the increase in mutual fund redemptions over the past two weeks, increase in bearish sentiment, the decrease in dumb money confidence, and the increase in smart money confidence, we are reaching an attractive valuation point for a good risk/reward opportunity. We are not saying the end of this correction has definitely occurred and it is possible that even deeper value may be created by the time the downturn has run its course; but we are likely closer to the end of the move than the beginning.