By Sasha Cekerevac for Investment Contrarians | Aug 9, 2013
Many friends and readers have been asking me about the overall market and when we will see a market correction occur. For simplicity’s sake, let’s use the S&P 500 as a trading vehicle of choice to represent the overall market.
I believe we are close to a top in the S&P 500 and it could drop at least 150 points during the next market correction.
There are several reasons as to how I calculated the extent of the drop and how we are currently very close to the top. The first is that a market is a multiple of earnings—how much people are willing to pay for every dollar of earned income.
Historically, the average for the S&P 500 price-to-earnings (P/E) ratio has been about 15. A market correction occurs when there is a disconnect between the S&P 500 and the underlying fundamentals of the companies. Remember: the market leads the economy, which is exactly what has occurred over the past couple of years.
However, at this point, we are in a situation in which revenues are not growing, profit margins are close to all-time highs, and earnings appear to be stagnating. With the 12-month forward earnings per share for the S&P 500 estimated to be $117.00, this leaves the forward P/E ratio for the S&P 500 at 14.5. (Source: FactSet, August 2, 2013.)
Is that outrageously expensive? No; however, it isn’t cheap. We need to look at where the risks and the potential rewards are to get a better idea of whether or not a market correction is likely.
In terms of rewards, the historic P/E ratio for the S&P 500 again averages around 15. So yes, we could see a slightly higher multiple for the S&P 500. But since earnings are stagnating and revenues are not growing, investors will become more hesitant to pay a premium in that type of environment. In this case, rewards seem limited.