PE ratio diverges from S&P 500

The S&P 500 (SPX) closed in red at 2,737.76 (-0.22%) on Thursday (November 29, 2018), but the two other US major indexes ( DJIA and Nasdaq) closed lower during Thursday’s trading session.

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The Fed chairman, Jay Powell said U.S. interest rate level is just below neutral for the economy. What he meant is rates will not rise as much as investors had anticipated. At first, the reaction in the stock market was positive. The market got Powell’s remarks as dovish.

But interest rates alone are not the issue, there are other fundamental problems that will continue to be a drag on the economy. In particular, the amount of debt has increased significantly since the last crisis.

Let’s take a look at the charts. We are keen to find any divergence.

I have drawn a daily chart of the S&P 500 index (RHS) together the P/E ratio (LHS) to get a view of the market. This chart is from July 21, 2017.

The P/E ratio is figured by dividing the price of a stock by the company earnings per share. For example, a stock selling at $50, with earnings at $5 per share for the previous year, has a P/E ratio of 10 (50/5 = 10). This ratio can be calculated for an index as well.

The P/E ratio should generally track well the trend of the S&P 500 index. It has happened until the beginning of April 2017.

There has been a bearish divergence between the two ( S&P 500 and P/E ratio) starting with April 2017. The P/E ratio (black line) fell from above 26.5 to 24.6 in July 2017 while the S&P 500 (blue line) continued the uptrend.

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Let’s see the same chart how it looks today.

The P/E ratio has been declining since the beginning of 2018. The ratio line made lower highs and accelerated the falling in October (see the black line). It fell to around 22.0 in November. It does not seem to recover.

If you are a long-term investor, the sell-off should present opportunities to accumulate quality stocks with low P/E ratio.

The above references the authors opinion and is for information purposes only. It is not intended to be investment advice. Seek a duly licensed professional for investment advice.

Dan has been analysing professionally financial markets for more than a decade. His career was spent serving both in the banking industry and asset management. Dan’s expertise includes global macroeconomics, corporate banking and portfolio management. He has Master degrees from both French Pantheon Assas Paris II University and British London Metropolitan University.
TA qualifications: CFT, MSTA

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