Earnings for the just reported 3rd quarter were not really anything to jump up and shot about. In general they have achieved expectations, but leading into the quarter, analysts had been downgrading their expectations. With the combination of strong S&P 500 performance and so-so earnings, we now see the S&P 500 selling at a forward P/E of 14.8x.
Of course, it is impossible to determine from the chart above what is normal for the P/E. One of the better ways throughout history was to compare the P/E ratio to the inflation rate, and using our Rule of 20, you can see below that this discipline says the P/E in normal emotional times could go up to 17.5 before getting back to that "normal" red line projection.
It is hard to believe in this negative environment for consumer sentiment expectations that investors are actually returning to a "normal" environment of valuation. Of course, with the Fed pumping reserves into the system through their massive bond buying program, and with unemployment still relatively high putting a lid on wages, we could see that red line (Rule of 20) come down somewhat, but the spread between the two lines gives a lot of room for a continued improvement in P/E ratios and a higher stock market.
We say this, but we also continue to suggest that the short-term has enough risk involved to keep some money on the sidelines in case we do see any overall correction.
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