Where Does Valuation Stand as the S&P 500 Reaches New Highs?

So, we now have another new all-time high on the S&P 500.

This has brought the index up to the point where it is now selling at 14 times forward earnings for the first time in a while.

As we say, the price-to-earnings (P/E) ratio has a long-time historical relationship with inflation.  That has been the basis of the Rule of 18-22, saying that inflation plus the P/E ratio should bee in the 18-22 range when fairly valued.  However, markets are NEVER "fairly valued" when fear is high.  When fear starts to subside though, P/E ratios move up (and vice versa).  So when our Fear Index (the price of gold) dropped under that major resistance point a few weeks ago, just like summer follows winter, the P/E ratio has moved up.

There is another similar discipline that we chart for subscribers to our site.  It is called the Rule of 20, and it says that the normal (neutral fear) P/E ratio can be determined by subtracting the inflation rate from 20.  You can see that plot below.

We have been expecting the forward P/E (blue line) to converge with the Rule of 20 P/E (red line), as a harbinger of better emotional feelings.  That is now starting, and it also confirms the message given when the price of gold dropped under support a few weeks ago.

Don Hays

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