The historic rule of thumb is that the S&P500 is correctly valued with a price/earnings or PE ratio of 14, the market normally hits the area of 7 at true bear market bottoms, and 21 at bull market tops.

There are 2 types of PE ratio that S&P produce the first ratio is called the OPERATING Earnings. This is basically the PE ratio calculated with all the bad news stripped out, it is the make believe PE ratio that has very little to do with reality and only has any validity in the fantasy land of CNBC and Wall Street analysts. The other ratio are as REPORTED or real earnings, the giveaway is in the name as these are the earnings that are actually reported to the SEC via the 10Q form each quarter.

These reported earnings are the only reality, as another giveaway is that during every boom these 2 ratios fantasy and reality actually close up they become very close in value, and during every bust we get huge divergences. For example during the last bust the highest Reported PE ratio recorded was 46 which was also the highest PE ratio ever recorded in history! At this same time, the operating PE was 29.

Today with 53% of companies' results reported for the 2nd quarter 2009 the Operating PE is surprise, surprise "only" at 22.87. So according to CNBC and Wall Street the S&P 500 is fairly valued so please ignore reality, live in denial and BUY!!! Unfortunately the reality shown by the as reported PE is a truly mind blowing 723. I repeat 723, the previous all time high was 46.

Despite this incredible PE ratio the S&P500 has been rising in value and rising strongly, this can only mean a few things.

1 S&P 500 market participants are really very stupid, by buying an S&P500 share via a proxy instrument such as the SPY it will take them 723 years to get there money back. As the price you pay will be 723 times the earnings actually generated. Why is Warren Buffet a renowned value investor, recommending that the ordinary person now buys stocks when at this point they have such a ridiculous historical valuation?

2 S&P500 market participants prefer to use the fantasy all overheads striped out operating earnings PE ratio, and simply ignore reality as it is far easier to live in denial.

3 The remaining S&P 500 constituents who have not reported yet are going to produce truly knockout earnings, so that the final as reported S&P500 PE ratio will once again make sense and be back in line at about 14.

4 The market is a forward looking mechanism and is forecasting the mother of all inflations. This would mean that the PE ratio would close back towards more historic norms. The S&P 500 constituent companies are multinationals, thereby generating foreign earnings. Lets use McDonalds' as an example if they sell a meal in Paris and make 1 Euro profit and for ease of illustration assume that is all the profit they make that quarter and lets also assume they only have 1 share traded. Finally the exchange rate is 1 Euro = 1 Dollar. It means they now have $1 earnings to report on there quarterly 10Q. So that single McDonalds share would be fairly valued at $14 as it produces $1 of earnings, the McDonalds share would then have an as reported PE ratio of 14. 

If because of massive inflation caused by the FED,s reckless money printing to bail out Wall Streets recent madness and the Governments excessive spending. The exchange rate slipped so that now 1 Euro = 5 Dollars, and lets assume that Mcdonalds sell the same meal and make the same 1 Euro profit. They now have $5 profit to report on there 10Q . The earnings for the one share would be $5. So that single McDonalds share would be fairly valued at $70 as it produces $5 of earnings, the McDonalds share would still have an as reported PE ratio of 14.

It is all, a game of smoke and mirrors, the talking heads on CNBC would be talking about a blow out earnings quarter at McDonalds, Goldman Sachs would reiterate there BUY recommendation, the CEO of Mcdonalds would have a huge performance bonus paid for his Fantastic work.

Only slight problem Mcdonalds still only made 1 Euro profit, the share price moved radically higher only because the measuring unit the US $, has actually received a massive deflation in its purchasing power.

5 The S&P 500 is due an imminent crash in the region of 98% which would be necessary so that it is back in line with the historic PE ratio of 14.

6 The Government, Fed, and Wall Street are printing money and buying S&P500 futures contracts to keep the market at this level and PE ratio be damned.

Looking at the 6 scenarios above, Number 1 applies if you are an extremely long term investor with a time window for your investment of 723 years. As regards number 2 the talking heads AKA Wall Street propaganda machine constantly hammer the "better than expected" fantasy operating earnings, I guess the terminally naïve amongst us will trade the S&P500 LONG based on this "advice".

Number 3 is simply not going to happen about as likely as Wall Street coming clean and actually telling the truth for once.

Which leads us to the far more likely scenarios of 4,5 and 6. Personally I feel we are due a blizzard of inflation to inflate away all the debts to more manageable levels as the western worlds consumers, corporate,s and Governments are all tapped out, and we still have the complete financial debacle of the boomers retirement to face. A detective always looks for a motive behind any crime. The Government has plenty of motives to try and inflate the debt problem away.

However to save the S&P500 and restore sanity, the inflation required and therefore by definition destruction of the purchasing power of the Federal Reserve note the US dollar will have to be truly historic, so I feel probably starting this autumn after the low volume holiday period we have further declines in the S&P 500 as per scenario 5, not 98% but a large decline from present levels and very probably the eventual destination is new lows.

At opportune times they will intervene to "support" the market, so much for the principle of the free market. First rule to recognize regarding the supposed free markets = THERE ARE NO FREE MARKETS ANYMORE, simply degrees of manipulation. It is also extremely difficult to tell if JP MorganChase and Goldman Sachs are actually public companies anymore or simply extensions of the United States Federal Government, the relationships seem beyond cosy.

Which ever scenario eventually plays out, I can promise you one thing something has to give and quickly as a reported PE ratio of 723 on the S&P 500 is simply not sustainable. It is going to take manipulation, huge inflation or a major correction, or a combination of all 3 but something has to give.

Because of the required Dollar devaluation to hold the S&P 500 flagship index together, with the restoration of a sane PE ratio, we believe that Gold and Silver are the true real buys at this point.