The Market's Primed For A Pullback

By Thomas Smith | September 07, 2009 AAA
The Market's Primed For A Pullback

The stock market has raced from its March lows to a point where the S&P 500 Index is now trading around 1000. This level translates into a price-earnings (P/E) ratio of over 126, based on the most recent 12-month reported earnings. You can talk about "green shoots" all you want, but I am a numbers person and the numbers tell me that this stock market is overdue for a major pullback.

Earnings Yield
Most investors understand what a P/E ratio is and how it is calculated, but few understand that its real significance can only be seen when it is turned upside down (earnings/price). This inversion of the P/E ratio is referred to as the earnings yield and right now the earnings yield on the S&P 500 Index is a paltry 0.80%! By comparison, the average five-year corporate bond is currently yielding around 4% - five times as much as the index. The difference in those yields makes no sense. (Learn more in Is The P/E Ratio A Good Market-Timing Indicator?)

Unequal Earnings
Earnings belong to the stockholders, though many stock investors often overlook this point. Whether the earnings are paid out in the form of dividends or retained by the company, they still technically belong to the shareholders. This is why the E/P is called the earnings yield. Its significance is that it serves as a guide to determining a rational price for a stock.

Recognition of earnings yield allows you to make an easy comparison to the many other, more familiar fixed-income investments you have access to, such as CDs and bonds. So tell me, why would you buy a "bond" that is yielding 0.80% when you could instead buy one that is yielding 4%? Well, the answer, of course, is that stock earnings are supposed to grow. As a result, based on the price you paid today, the earnings yield is supposed to grow. But how much earnings growth do you need over the next five years to equal the 4% bond yield? The answer is: a lot! (Learn more about CDs in our tutorial: Certificates Of Deposit.)

Is the Market Priced Too High?
It's really a matter of simple math. The average five-year corporate bond yielding 4% will result in a cumulative yield of 20% over the next five years. At 0.80%, the earnings yield on the S&P 500 Index would have to grow at a rate of 60% - compounded annually - to sum to 20% over five years. That means that by 2014, the current 12-month reported earnings of $7.92 on the S&P 500 Index would have to rebound to over $83 – nearly back to its high-water mark back in 2007.

No Good News
Hey, I don't have a crystal ball. Anything is possible. But, I don't see nearly enough good news on the economic horizon to make me want to take that bet. In 1929 the earnings on the Dow Jones Industrial Average (DJIA) peaked at $19.90 before taking a header. It didn't see that level again until 1948! (Read more about the Dow's movements in How Now, Dow? What Moves The DJIA?)

So what's the action item? I suggest you step away from all except the highest quality stocks at this point. Go to cash or even go to bonds. That corporate bond yield looks pretty good to me. How about a nice corporate bond ETF? As stock levels pull back and earnings begin to show sustained recovery, the earnings yield will once again become competitive. Then, and only then, will it be time to fully embrace stocks once again. (Read more in Bond ETFs: A Viable Alternative.)

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