The US stock market continues it resilience, which surprises me since I do not see any additional steam coming through: all good news are priced and bad news ignored; this cannot last for ever, whilst I am not denying that markets can diverge from reality for a long time. Risks of a larger correction are only increasing.
Today's chart illustrates how the recent plunge in earnings has impacted the current valuation of the stock market as measured by the price to earnings ratio (PE ratio). From 1936 into the late 1980s, the PE ratio tended to peak in the low 20s (red line) and trough somewhere around seven (green line). The price investors were willing to pay for a dollar of earnings increased during the dot-com boom (late 1990s) and the dot-com bust (early 2000s). As a result of the recent plunge in earnings and recent stock market rally, the PE ratio spiked and just peaked at 144 – a record high (Japanese style before the stock market crashed - I do not predict this, different time, different situation).
Currently, with 97% of US corporations having reported for Q2 2009, the PE ratio now stands at a lofty 129. At constant market prices, earnings have to be multiplied sixfold to go back to the historical average. Yes markets anticipate, but I doubt that 1) we will see earning recover by the magnitude withing 12-18 months and 2) that markets anticipate earning further away. Draw your own conclusions.