Wednesday, November 09, 2005

The S&P 500 index is undervalued

The P/E ratio of the S&P 500 is near a 10-year low. According to Standard & Poor's, the total reported earnings through 9/30/05 for the sum of the components of the S&P 500 was about $67/share. As of today, the S&P 500 index trades at about 1220. Accordingly, the trailing P/E ratio of the S&P 500 index is about 18.21 (1220/$67). The last time the trailing P/E ratio was this low was 10 years ago, at the end of 1995 when it was about 18.14 at the end of the Dec. 1995 quarter.

While the trailing P/E is attractive right now, the forward P/E looks even better. Standard & Poor's projects the earnings on the index for 2006 to be about $78.30, giving a forward P/E ratio of about 15.58 (1220/$78.30).

Is this a "buy" signal? I sure think so. Stocks have recently been weighed down by high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low by historical standards. Moreover, relative to bonds, stocks look extremely attractive. The yield on the 10-yr US bond has recently risen sharply to 4.67%. In other words, despite the recent rise in bond yields, they are still priced as though there is no heavy inflation on the horizon.

Accordingly, I am led to the conclusion that stocks are due for a strong rally. Although corporate profits have been strong for several years now, stocks haven't done much since their strong surge in 2003. So I think that a rally is long overdue. It would not surprise me to see a 30% year-over-year rally in the S&P 500.

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