Valuations matter in the long run. That's important to remember. Especially at times like this when almost every valuation metric indicates the stock market is expensive.
There are many definitions of these terms, but, to me, valuation metrics are tools to normalize the relationship between stock prices and fundamentals. Popular metrics include the price-to-earnings (P/E) ratio and price-to-sales (P/S) ratio. There are dozens of these indicators, and each has its advantages and disadvantages.
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Normalizing is a way to make numbers comparable. For example, if we are talking about company earnings, we might find one company has $10 million in earnings and another has $100 million in earnings. By itself, this information really doesn't tell investors anything about how the stock is valued.
To make earnings more comparable, companies often report earnings per share (EPS). Assuming the first company has 10 million shares and the second has 100 million shares, the EPS for both is $1. Earnings are normalized with EPS.
But we still don't know anything about the stock price. That's where the P/E ratio comes in. If the first stock traded at $10 and the second at $30, the P/E ratio of the first is 10 and the second is 30.
This indicates investors are paying $10 for $1 in earnings for one company and $30 for the same dollar of earnings in the second. We still don't know which stock really offers more value. We would want to know more about profit margins, earnings growth and other variables.
If we assume the companies have the same profit margins and earnings growth rate, we can see that the lower P/E ratio offers more value.
This illustrates the P/E ratio is useful and the concept of normalizing data is important for analysis. That's why the chart below offers an important warning for investors.
Source: Advisor Perspectives
This chart normalizes the P/E ratio of the broad stock market since 1900. The P/E ratio used is based on 10 years' worth of earnings and is corrected for inflation.
In the chart, the value of the P/E ratio is assigned a percentile. Higher percentiles indicate the stock market is potentially overvalued. The current reading is higher than 95.3% of the historical data.
This is higher than the stock market peak in 2007. But it is below the peak of the stock market bubble in 1929 and the levels seen in the internet bubble in the late 1990s. The tech bubble is shown in orange and demonstrates that valuations can remain high for an extended period of time.
Other valuation metrics show a similar pattern. The broader stock market is potentially overvalued. But it can remain overvalued for years so this is not, in itself, a call for action. But it is a warning that risks are elevated. This is shown in the next chart.
Source: CMG Wealth
This chart shows that when the stock market declines, the size of the losses tends to be larger when the P/E ratio at the beginning of the decline is highest. The relationship between risk and valuation is clear and steady in this chart.
The high valuation in the current market is also a warning that returns are likely to be below average. Looking ahead, returns over the next 10 years average just 4.3% per year when the P/E starts from a level in the top 20% of historic ratios. Remember, we are now higher than 95.3% of all previous ratios.
This compares to an average annual gain of 15.7% when the starting point is a P/E ratio in the lowest 20% of historic ratios.
Based On This Data, Here's How I'm Trading
This is all a long-term perspective. What it tells me is that a balanced portfolio makes sense in the current market. For my Profit Amplifier readers and myself, this means a combination of put and call options could be the best strategy for this market. The puts will benefit if there is a decline, and the calls can benefit from gains.
In the short term, put options could offer the best opportunities The next chart shows the S&P 500 with the Profit Amplifier Momentum (PAM) indicator at the bottom. The 40-week moving average (MA) is also shown.
PAM turned bearish last week as the price slipped below the 40-week MA. These are indications the stock market could be in the early stages of a selloff.
Now, that doesn't mean prices will go straight down. Monthly options will expire this week. In the past, the S&P 500 has moved higher 68.6% of the time during the March expiration week. That's significantly better than an average week when the S&P 500 delivers a gain just 56% of the time.
There is a significant bullish bias for the coming week. But in the longer term, there are significant bearish pressures in the market. This is a trader's market since short-term trading will give us the opportunity to benefit from the swings that will occur in price.
As I mentioned earlier, that's good news for my Profit Amplifier readers. By using our proven system, we're able to make quick trades on stocks in either direction. What's more, we're able to turn moves of just a few percentage points into gains of 10.4%, 58.9%, and even 60% or more in a matter of days. If you'd like to know more about our strategy -- and get your hands on what could be the biggest trade of the year -- check out this briefing.
(This article originally appeared on StreetAuthority.com.)