To value the market I use real adjusted PE ratio, basically the average S&P earnings over the last 10 years adjusted for inflation rate to get real earnings.
The market's long term real-average PE is 17 time earnings; we need another 20% decline assuming no growth in earnings to get to that level, the market's current adjusted PE level is 21. But generally speaking markets need to correct even more to balance out and the more it overshoots to the upside the more it tends to correct to the downside. If you look to the PE chart you will see that every time the market has rallied the PE tends to decline well below the long term averages.
In the 1929 bubble the S&P reached its second highest real PE ratio the market corrected in a nasty and violent way all the way to around 5 times earnings. The highest PE ratio was reached in 2000, so we are still adjusting from that peak. The process may take longer than many anticipate. The market can behave in one of the following scenarios to get to attractive valuation:
- Moderate growth in earnings combined with another 20-30% decline in S&P. A highly probable scenario.
- Above average real growth in earnings with 10-20% decline in prices, which may be not very likely in the next few quarters given all the challenges the global economy faces.
- Earnings will violently decline with quick price drop in the S&P. Not very likely given the decent economic activity in the rest of the world and semi-decent US economic engine.