There is probably no better indicator of market volatility than the current price to earnings ratio of the S&P 500. The market volatility is spectacular and we are seeing more gyrations in this recession than we did during the Great Depression. Since March when the S&P 500 touched the 666 mark, the rally has boosted the index by 54 percent. Was this caused by stunning second quarter earnings? Absolutely not. With nearly 97 percent of all companies now reporting earnings for the second quarter, the S&P 500 PE ratio sits at 129. This is by far the most over hyped rally in the world.

First, let us look at this insanity on a chart:

Source: Chart of the Day

I think when people see charts like this they start doubting the source. This unfortunately is accurate. Even during the Great Depression, when the market plunged to the depths, the PE ratio never even touched 20 and some of the many mini-rallies after the crash of 1929 involved legitimate looks at low PE ratios. A PE ratio is important because it factors in the price of a stock to the actual earnings. This matters. Even right before the tech bubble burst in 2000 the S&P 500 had a PE ratio over 40 and this was extremely expensive. In this case, we have 26,000,000 Americans unemployed or underemployed and earnings are simply not there with consumers pulling back. So what is causing this massive rally if not earnings? This recent rally is being driven by the “getting less worse” mentality. Sure, we lost 247,000 official jobs last month but sure beats 700,000! Okay, earnings are way low but it beats actually losing money! This kind of thinking is leading many sheep to the slaughter again.

Take a look at some of the official data from S&P itself:

Source: S&P

At the end of last month, only three weeks ago the S&P 500 data had the PE ratio at 143. So to currently have it at 129 is a slight improvement. But with only 3 percent of companies reporting to close out the quarter, we are massively over priced. We have never seen the entire index suffer a negative earnings quarter that is until recently. So the crash wasn’t a panic but actually based on declining earnings. That quarter saw $202 billion in negative earnings (losses) from S&P 500 companies reporting. Q1 of 2009 saw reported earnings come in at $7.52 per share. So right now, everything looks good when looking from the ground up.

Yet to show you how off predictions have been and how wrong analyst can have earnings, let us look at the Q3 2009 estimates and how they have evolved over one year:

Now this chart is something. Back in June of last year, the Q3 2009 estimate was coming in at $27.68. Keep in mind we were already in recession at that point. In September of 2008, the EPS didn’t change much for analysts. After the market crashed and the U.S. Treasury and Federal Reserve had to step in to save the financial world supposedly, they finally revised earnings lower. The market went lower and lower and now, the latest estimate for Q3 of 2009 earnings is $14.57. This new revised estimate is a drop of 47 percent from the June 2008 estimate. Sounds about right with the market. Yet the market is up 50 percent while earnings estimates are down by 50 percent. Any value investor will tell you that looking at PE ratios is absolutely crucial. Some of the top experts avoided the tech stock mania because they were seeing stocks with PE ratios of 100 or even 200 on the prospect of making it big. Some did survive but the vast majority didn’t. Even a high flying stock like Google has a PE slightly above 30.

Now assuming the $14.57 EPS for Q3 of 2009. Is this necessarily good?

1026 (current S&P level) / ($14.57 estimated EPS) = 70 PE ratio

Even with this estimate, the PE ratio would still be at 70! At record levels. And keep in mind, a big jump of earnings in these last few quarters involved massive infusions of free money into the banking sector. Do they not realize that there are still some $3 trillion in toxic commercial real estate debt left? Of course on the estimates, you can see that the financial sector is having the best expectations. The industry that brought us the credit and housing bubble is now going to lead us out of this massive recession. We are in good hands.

Many now agree that this is the worst recession since the Great Depression. Yet many think things will turn around in a few months. These kind of market dislocations last years and impact generational thinking. There is a new austerity out in the market. In fact, this new spending habit is taking hold so deeply that the government had to entice people to trash their working vehicle for a new car. People are surprised that the cash for clunkers program worked. How are they shocked? Free money for your bucket and a new car? Who could have ever seen that coming!

Yet even the analyst estimates put the S&P 500 at a PE ratio of 70 for Q3 of 2009. A more normal average PE ratio even at the high end would be 20. From the mid-1930s to the 1980s the PE range would peak out in the low 20s. But then, the technology bubble and housing bubble gave us two decades of wild valuations. But let us assume a high 20 PE ratio. What should the stock market be valued at?

(X/ $14.57 Q3 2009 estimate) = 20 PE ratio

291.40

This is the insanity of the current market. For the PE ratio to come in at 20 for Q3 of 2009 and with estimated earnings of $14.57 per share, the S&P should have a value of 291.40. This is even less than that the 666 low reached in March. So why the rally? Because people believe we’ll be back to peak earnings again. And insiders seem to have a different opinion. Last week, insiders had 18 buys for $30 million while on the sell side some 131 sold for over $889 million. Maybe the insiders know something that the public doesn’t regarding the S&P casino?

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