Even fundamental analysts appreciate this site, which shows at a glance the P/E ratio for the total S&P 500. You can track that number historically and see where it is trending, which can help you identify when the stock market enters overbought and oversold territory.
Now we’re above 19, or 32% above the median. The overall chart shows clear up-and-down momentum in the long term, with us now on an upward curve from a dip that resulted from the fallout of the subprime financial crisis.
Swing traders want to play that curve and try to identify when it’s gone too high or too low, then use that information to make a quick buck. Those who believe in the Efficient Market Hypothesis say that it is impossible to do this sustainably over time, because the market is inherently efficient. But the EMH also suggests that stock picking is a “random walk” and no one will outbeat just betting on the S&P 500 steadily, over time, taking the good with the bad.
Hedge funds and investment banks disagree with that idea–they have to. Their raison d’etre is to find and exploit inefficiencies in the market, which they recognize before anyone else. Some say this is easier to do in private equity, but for the common stock market it means identifying opportunities of creating value, often by simply finding an equity that has been undervalued by the market and buying it, then waiting until the market has found its value.
At its core, this kind of value investing takes fundamental analysis as its compass, but studying just what is happening in a company is short-sighted. Companies exist in a larger macroeconomic context, and that context can often determine the failure or success of that company’s business model.
This is where the P/E ratio of the S&P 500 comes in. By looking at how the larger market is doing, and whether stocks are in general overvalued or undervalued, can help you determine the reasonableness of the market’s valuation for a particular stock. It can also tell you if the market is heading for a bubble.
Such indicators are great for risk management, and professionals use them to aid in price discovery and in timing when to increase or decrease their positions. Currently, the high P/E ratio for the S&P 500 and the strong performance of the market, combined with stubbornly high unemployment, stagnant wages, the proximity to a liquidity trap, rising bond rates, and concerns about the U.S. government’s ability to agree on a budget, are all risk factors that analysts need to weigh against that high number. Going into the last quarter of 2013, investors will be wise to keep a close eye on the S&P 500 as they begin to think about expectations for equity markets in 2014, and how this impacts their own portfolios and stock picks.