Bullish investors argue that the summer sell-off in equities has knocked stock valuations down to such a degree that exchange traded funds are cheap and safe to buy.
The price-to-earnings ratio for the S&P 500 has dropped to a level not seen since 1990, according to Chart of the Day.
However, there are caveats. If the economy slips into another recession, then Wall Street’s current earnings forecasts could end up being way too optimistic.
“We are now back at normal P/Es where some might even say that the market is cheap,” writes J.C. Parets at All Star Charts. “But can it get cheaper? Of course. The problem here is the ‘E’ [earnings]in P/E. We don’t know what the earnings are going to look like. All we have are estimates – and they’re always getting revised.”
Indeed, earnings estimates have been too rosy in recent economic pullbacks, especially in the 2007-2009 “Great Recession.”
“Wall Street is one of the few places where practice does not make perfect,” according to a Bianco Research presentation posted at The Big Picture blog.
“If the economy goes into recession, earnings forecasts are not 10% to 12% too high. Instead they might be 20% to 40% too high. In other words, if the economy goes into recession, the earnings forecasts are horribly wrong,” Bianco states. “They might be so wrong that one can make the case that the market might be overvalued. We believe this is part of what is bothering the markets, the epiphany that the economy is much weaker than expected and a recession will blow a hole in earnings forecasts to the point that the market might not be cheap anymore.”
Bloomberg reported the rout in stocks has pushed S&P 500 valuations 25% below the average level from the last nine recessions as profit estimates fall with stock prices. Companies in the blue-chip index are trading at just above 10 times 2012 forecast earnings, according to the report. [Stock ETF Sell-Off Attracts Value Investors]
iShares S&P 500
