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Market Extra

Aug. 18, 2022, 9:14 a.m. EDT

This popular stock valuation tool may be leading investors down a ‘dangerous’ path

By Barbara Kollmeyer

“Dangerous assumptions” are currently embedded in a popular on valuation tool for stocks and the market as a whole — price/earnings (P/E) ratios — writes Jesse Felder, of the Felder Report.

Earnings “unduly depressed” due to recession or overinflated where economies are healthy, can result in a P/E that’s dramatically elevated at the bottom of a cycle or too depressed at the top, Felder notes.

Investors remain concerned about the possibility of the U.S. slipping into a recession, as the Federal Reserve and other global central banks hike interest rates to fight soaring inflation. Prices for many goods and commodities have been climbing this year, exacerbated by Russia’s nearly six-month war in Ukraine.

Read: 5 things we’ve learned from earnings season  

Felder notes the S&P 500 index (S&P:SPX) is currently trading on a P/E ratio of 21 times trailing 12-month operating earnings and 18 based on analyst estimates of those earnings over the next 12 months. He said those levels are roughly average relative to the past five years, which would lead some to the conclusion that the market is fairly valued.

“However, it’s crucial to note that the profit margins underlying those earnings currently sit at their highest levels in decades (if not in history),” said Felder, adding that if those fall, investors will soon realize earnings were overinflated and P/E ratios misleadingly low.

Read: SocGen strategist Albert Edwards declares the Ice Age is over. Bring on, the Great Melt as inflation heats up.

And: This rule with a perfect record says the market hasn’t bottomed, says Bank of America’s star analyst

Link to MarketWatch's Slice.