Sunday, November 23, 2008

Is the Market Undervalued?

click to enlarge chart

The S&P 500 index is now trading 49.4% off its 2007 peak. Some analysts are saying the Market is undervalued and this is a great time to put capital at risk in the stock market. Maybe.

The Hussman "Prior Peak Earnings Model" (PPEM) is a good way to measure the market's valuation relative to prior bear market bottoms. As shown on the chart, secular bear markets often reach bottom when the S&P 500 index is trading at a multiple less than 10x prior peak earnings.

At the end of this week, the SPX closed at 800.03. At this level, the Market is trading at roughly 9.4x prior peak earnings, a level that is considered "undervalued." When the market has reached this valuation level in the past, stocks have ALWAYS outperformed T-bills over the next 10 year period.

But that is not saying that the Market can't first go lower from here before it goes higher. If the SPX dropped another 160 points (20%) from here to 640, the P/E would be 7.5x prior peak earnings, similar to the valuation trough of the bear market of 1983, 1980, 1974, 1949, and well above the valuation troughs of the bear markets of 1942, and 1932.

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