I know that the average stock investor is very happy with the overall market right now.
However, that is because their happiness level corresponds with the level of the market overall and right now stocks are high — so investors are flying high, too!
However, they don’t see the danger signs.
For instance, lately I’ve been telling my Ultimate Wealth Report subscribers and Absolute Profits subscribers that the average price-to-earnings ratio (P/E) of the S&P 500 is dangerously high.
That means that investors are paying top dollar for the earnings of these companies. The P/E of the S&P 500 most commonly tops out when the average P/E is in the 20-23 range.
Sometimes it tops out at only 18 and on rare occasion it will make it to an average P/E of 25.
(Note: As a point of reference, the S&P 500 is trading at a value when the P/E is in the 6-12 range. When it gets to the 14-16 range, the market is fairly priced. And when the P/E gets up to the 18-25 level, the market is overpriced and is in great danger of a huge correction lower.)
But for the most part, most tops in the market come after the S&P 500 gets to a P/E of 20-23.
The P/E of the S&P 500 is back up to 20 once again. So it doesn’t mean that stocks can’t go higher or that they have to correct tomorrow, next week or next month. No, what it does mean is that investors are paying too much for the average stock right now and they don’t realize it.
Before long, stocks will correct lower to wring these excessive valuations out of stocks to bring them back to a healthy level once again.
Well, there’s another way of looking at this that also confirms what I’m seeing. Each year in June, there is a calculation made to see what the median P/E is of all of the New York Stock Exchange-listed stocks that have had positive earnings during the past year.
This calculation has been done since 1951 through present. And there are only five times during that entire time period where the median P/E ratio got almost as high as it is now.
It happened once in 1962 and again in 1969. History shows us that the 1960s was practically a “lost decade” for stocks, treading water sideways at best.
Then the median P/E got almost as high as it is now in 1998. That’s when the S&P 500 went from the 1500 level down to the 800 level from year 2000 until 2002. That’s around a 47 percent drop. No, stocks didn’t crater the moment stocks got very expensive. To the contrary, it took some time, but once they did crater it was a huge fall.
Then in 2005, the median P/E got near today’s levels and in latter 2007 we had another huge stock crash from almost 1600 on the S&P 500 down to under the 700 level in 2009. That was an over 56 percent correction in the S&P 500!
As of June 2014, this median P/E calculation showed that the median P/E was higher than it’s ever been since they started keeping records of it in the 1950s! And stocks are higher now than they were in June. So the chances that the median P/E is even higher than the chart I saw are very likely!
There’s usually some time between when these P/E ratios peak out and when these enormous corrections come…but it’s coming!
The next thing I look at are the margin debt levels of the New York Stock Exchange. This shows how much money investors are borrowing from their brokers to buy stocks. The more bullish/fearless they are, the more they’ll borrow and go out on the limb.
However, the problem comes when stocks begin to correct and the margin clerks issue margin calls to accounts as they go into clients’ accounts and sell stocks to reduce the risk to the brokerage firm.
As this happens, it causes even more selling than it would if customers were just going into their own accounts and selling.
I mention margin debt levels right now because they are the highest on record as well. They’re higher than the margin debt peaks in March 2000 and July 2007. You’ll recall that when these margin levels peaked the huge stock market corrections came just weeks to mere months later.
The final warning sign I see is that the VIX is jumping all over the place violently. The VIX tracks the volatility of the S&P 500.
The jump in the readings of the VIX that normally happen over the course of a month’s time are now happening sometimes within a matter of days.
Additionally, you might normally see a spike in the VIX once every couple of months or so.
But lately, we had one huge jolt in December and two of them in January.
When the volatility in the market gets this frequent, it’s a sign that large institutions are very jittery about the levels of the market and they’re quicker to hit the sell button in their trading stations.
So all of these are huge warning signs for the investor that owns things like a mutual fund or ETF (exchange traded fund) that tracks the S&P 500, Dow or NASDAQ. It’s not good news for most mutual fund investors because most mutual funds track the market fairly well because they invest in many of the same stocks that the S&P 500, Dow & NASDAQ track.
Thankfully, in the Ultimate Wealth Report and Absolute Profits, we don’t buy stocks that track the market and have high P/E ratios, etc. But we’re the exception and not the rule.
Most investors have wide exposure to a broad market sell-off. So consider yourself forewarned, especially if you are anywhere close to retirement. You may not want to spend years riding through another decline trying to get back to where you were.
If you’re 25-35 reading this, it won’t matter all that much. But if you’re 55-65 or older, then it may matter a heck of a lot.
So review your portfolios to see what you’re invested in and how comfortable you are with your 401(k)s, IRAs, etc.
About the Author: Sean Hyman
Sean Hyman is a member of the Moneynews Financial Brain Trust. Click Here to read more of his articles. He is also the editor of Ultimate Wealth Report. Discover more by Clicking Here Now.
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