In the long term, stock prices reflect the earnings (profits) of companies. When asking why the stock market is down and when it is likely to recover, this chart is handy to remember. From the latest monthly economic indicator report published by the Joint Economic Committee of Congress (and prepared by the President's Council of Economic Advisers).
http://www.gpoaccess.gov/indicators/index.html
If we assume that stock prices reflect earnings (P/E values matter), prices will follow earnings...
Looking forward, as earnings start to recover, stocks may look quite attractive. See a Wall Street Journal graphic on global P/E rates below. Article is here.
Please note that there are two issues in trying to determine whether stocks are cheap or not. First, what is the P/E ratio below which stocks appear attractive? The chart below uses a long-term average (in green), but this is always open to question. Second, how do you measure earnings (trailing of the last 12 months, forward looking over the next 12 months, or using some moving average combining past, present and future earnings). Forward looking earnings are very inaccurate, earnings and earnings projections at the peak of the business cycle are naturally much higher than they are at the bottom of a cycle. Also do you look at operating earnings or some adjusted form of earnings. So different choices in measuring earnings yield widely different results in the measurements of P/E ratios.
According to S&P, the combined 12 month trailing earnings for the S&P 500 as of Sept 2008 was $52.67. So simply divide the closing value of index on any given day by that earnings value to get a quick P/E estimate. On the close of markets on Oct 27th, the S&P 500 was about 850 and the P/E ratio was about 16. By Halloween (10/31) it was 968 and so the P/E ratio was over 18. But stock markets are about projecting forward and guessing when earnings will rebound and to what level is the real challenge.
Here is link to another good chart looking at P/E ratios historically (from Ned Davis Research).
Here is a matrix showing different prices varying P/E ratios and projected earnings for the S&P 500 (forward looking for 2009) from the
Bespoke Investment Group.
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