I have advocated for a long time to look at P/Es computed based on both one year and ten year trailing earnings, as one year trailing earnings are easily skewed by economic cyclicality.   Over last couple of years, S&P 500 earnings were skewed dramatically by all time high corporate profit margins, which made the stock market appear cheaper than it really was.

Today, both P/Es tell a similar story – corporate profit margins are contracting and the S&P’s earnings are being revised down from approximately 80 to around 54.  To date, most of the carnage in profit margins was caused by losses in the financial sector, but the industrial, energy, and materials sectors (I call them “stuff” stocks) are starting to take over the profit margin compression torch as we speak.  These stocks did well during the last five years due to global expansion, but now face serious challenges.

I have updated the P/E charts that appear in my book.  Since trailing 2007 earnings no longer represent the economic reality of today’s environment, I used the S&P 500 earnings estimates for 2008 to show where we stand today. Since we are very close to year end, these estimates should be reasonably accurate. 

The chart below was prepared on October 14 (based on an S&P valuation of 998), and it shows that, based on one year trailing/estimated P/Es, we are still at an above average valuation.  The P/E is 18, and historically bull markets have started at valuations between 7 and 11.  The average P/E has been 15.2.  Unfortunately, we still have a way to go.

The same story plays out when you look at trailing 10 year earnings:

Here, we can see that P/E levels are at approximately 20, but bull markets start at levels between 7 and 13, and the average P/E was 18.3.

Overall, relative to historical valuations, stocks are still trading at above average levels.  We are not at end of the range-bound market which began in January of 2000.  [For a discussion of Vitaliy’s definition of a range-bound market, see our previous interview with him earlier this year.]

Although I hate to be the bearer of bad news about the stock market as a whole, the bad news applies only to investors that are taking a very passive approach – buying a broad market index fund or defaulting to a traditional buy and never sell approach.  Money still is to be made in the stock market, but it will require a more active – as well as disciplined - approach.  Being in stocks is not good enough - not anymore. You want to be in the right stocks.  Stock selection is paramount.