One of the factors contributing to yesterday’s selloff (the largest one-day selloff since last September) was some research from Goldman Sachs highlighting “lofty” valuations. (Usually Goldman is a lot more rosy with its outlook, so this received a great deal of attention from the press).
One the charts accompanying the research (see chart above) illustrates how high the Price-to-Earnings ratio is for the U.S. market when compared to other years since 1976. As we can see, it was only during the heights of the tech bubble when the Price-to-Earnings ratio was higher.
That said, the Price-to-Earnings ratio would have been a lot lower if it was not for the U.S. Federal Reserve’s money-printing policy of Quantitative Easing. Normally, towards the end of Secular Bear Markets (like the one that we have been in since March 2000), the Price-to-Earnings ratio for the market approaches 9, and possible even as low as 8. This sets up some risk for equity investors in the U.S. as the rate of Quantitative Easing is “Tapered.” Unless there is some spectacular earning growth very soon, it will be difficult to justify the high Price-to-Earnings ratio as the amount of liquidity for investment stops growing.
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