Thursday, August 20, 2009

On the way to euphoria

As the US equity market rally continues, many point out that the S&P500 is still 21% below last year's level. We still have ways to go just to get to last year's levels. Stocks are still cheap. Right.

The chart below shows the S&P500 level as well as the PE ratio, both the trailing ratio and the estimated PE (based on Bloomberg survey). Both PE ratios are at multi-year highs. The projected PE number of nearly 17 times earnings is particularly troubling because it's a forward looking measure. These levels indicate that equities are really expensive.

So why are people buying stocks with such enthusiasm? A few possible reasons here:
1. analysts are completely underestimating next year's projected earnings,
2. earnings growth in the next few years will significantly exceed historical growth,
3. stock market euphoria is back.

According to Credit Suisse, number 3 is more likely, or at least on the way there. The following chart shows the levels of risk appetite in the system, and we may be on our way from "panic" to "euphoria" in a matter of a few months.

Euphoria has been known to carry asset levels way beyond fundamental valuation, and that's exactly what may be happening here.

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