Valuations Need To Fall Further for a Sustainable Rally

Last week we discussed Robert Shiller’s S&P500 trailing 10-year price earnings ratio that has averaged 16.3 since 1881 and the fact that it had dropped to 15 as of October 10^th. While we saw prices increase last week and a rise in P/Es, what does the longer-term future hold?

In our next chart, we show annual trailing 10-year P/Es from 1920 to August 2008 using Dr. Shiller’s data. As we see from this chart, every major recession has resulted in P/Es falling below 10 for an extended period of time - lasting decades, not years - typical of secular bear markets. Click to enlarge:

At 15 last week, the P/E was back to just below the long-term average, but this was a daily drop, not an annual P/E. It will take many more months (possibly a year or more) to get back below 15 on an annual basis, meaning we probably won’t see this occurring till 2009 or even 2010.

After that, it could take a few more years to get back to single digits like we had during the last major recession in 1981-1982. In other words, markets and economies will need a long rest with P/Es below 10 before they will be able to mount the next sustainable bull market. A similar situation occurred during the Great Depression into the early 1950s, as we see from the chart above.

Could we get another cyclical bull market rally lasting a few weeks, months or even years as we saw between 2003 and 2007? Very possibly, but as we learned, more often such rallies are short-term and often end abruptly and rather unexpectedly. There are also the raft of fundamental financial challenges facing a sustained U.S. economic recovery like the crushing levels of debt, rapidly deflating derivatives and housing bubbles, falling Treasury sales and mounting government deficit as a result of more than $2 trillion in bailouts so far.

But that doesn’t mean you can’t make money trading the powerful reactive rallies embedded in every secular bear market. This is a trader’s market where it's important to set tight stops and take profits off the table regularly, not a time to buy and hold for the long-term, as the so-called pundits would have us believe, if we are in a true secular bear market.

found at: http://seekingalpha.com/article/100666-valuations-need-to-fall-further-for-a-sustainable-rally?source=feed