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PE and Yield Curve as market predictors

Comparing historical Price to Earnings and yield curve charts with market waves.

PE ratios

I’ve heard people saying lately that PE ratios are climbing to levels that
tend to precede market crashes.  I wanted to research that.

This interactive chart apparently lags by 12 months. 

A couple of strange things.

Why did the PE ratio go up so much more in 2008?  This chart shows a spike
where it goes up by 6x, all at once.  And yet the stock market did not surge
in a similar way.

So, if stocks did not go up in price that much, I guess earnings fell off a cliff.
I guess the mortgage crisis suddenly temporarily seized up the economy?

Anyway, I’ve heard people talking about the PE ratio getting high.  It does look
like historically it’s most comfortable below the 20 line.

Since 2000 though, even on the big pullbacks, the ratio has not dipped very
far below the 20 line.  Why is that?  For whatever reasons, it seems like the
market is now valuing companies at a bigger multiple of their earnings, than

We could speculate that, since stock prices are really the market’s estimation
of the future value of companies, the implication is that corporate earnings
are not only growing, but accelerating.

Since this chart is lagging, it doesn’t tell us the PE ratio right now, as the market
climbs in to new territory.

This page says it’s estimated to be about 26

That is really not all that high.  But the lesson of 2008 tells us PE ratios can go
up for two reasons.  1. the stock market goes higher.  2. earnings dry up.

Yield curve

Another broad indicator that we can examine to try to determine the market phase
is the yield curve.

This is a fun chart to play with.  Drag your cursor over the market chart, and it shows
you what the yield curve was at that time.

Notice how it flattens out right before crashes.

What the yield curve shows is, the left side of the line is the Fed set rate for short
term interest.  Then as you go right, you get the yields on bonds of various duration,
which roughly corresponds to loan rates, and bank profit margins.

So when this flattens out, banks have stopped making money.  Then the market
crashes.  Why is that?

Again, we can speculate.  But, in any case, that is not the case right now.

I wish we could look at this further back in time.  But this one takes us through
the two waves of 2000 and 2008.

In 2000 the yield curve flattened out way up over 6%.  Then, in 2000, it flattened
out at just 4.7%.

Since 2009, even though the Fed rate has been 0%, the right side of the yield curve
has steadily fallen.  Last summer, it hit 2.3%.

So the question is, if the Fed continues raising rates as promised next year, will banks
start charging more interest?  The answer will have to do with how strong the
economy is, how much demand there is for loans.

This has been the problem throughout the whole “recovery” since 2009, not only
in the US, but Europe.  Difficulty finding enough takers for new loans.

If this continues to be the case, and the Fed starts to raise rates, this yield curve
could top flatten out at a measly 2.5% or so.

And, at quarter point raises, even 3 raises next year would only take the Fed rate
to 1.25% by this time next year.  So, at that rate, less than 1% per year, it would
take us 3 years to even get to 2.5%.

If the economy isn’t strong enough to allow rate raises at that pace, it’s amazingly
anemic.  Even that pace of raises is very weak.

Also, note, before the 2008 crash, the yield curve flattened out for around 2 years
before the market actually crashed.

Summary analysis

The market is likely to keep going up.  PE ratios are climbing, but can certainly climb
higher.  And the yield curve is not yet flat.

I think all signs point to the idea that the range doubling suggested in this 20 year SPX
chart is likely to get fulfilled.

This tops the SP 500 out at about 2450.  That is only 200 points away.  Only about 10 %.

Then I would not be surprised to see the market fall back to the old range top at about 2100,
then bounce.  Set up a range from 2100-2450 that could last for a while.  The last 300 point
range lasted almost two years.


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