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Today I have a terrific guest post from Dan Hung, of The Curious Investor. Dan was gracious enough to provide GrowYourFunds readers with a guest blog regarding the current state of the market. As someone who has read quite a few of Dan's posts, I can tell you that he is very thorough and provides some great analysis. I encourage my readers to signup for his RSS Feed.

Current State of the market- Dan Hung 

Markets corrected nearly 20 percent over the last half year or so and, finally, after some violent and panicked selling, it seems that we’re looking at some sort of a bottom. Is it now time to buy? Everything seems cheap now, right? Not so fast.

Many believe that after the excesses of the internet bubble (circa 2000), our markets entered a post-bull trading range not dissimilar to that which U.S. equities saw between 1966 and 1982. What exactly is a post-bull trading range? Essentially, it is a period in which the market “pays back” the wild appreciation that it enjoyed in the years prior. These ranges are characterized by rapid blast offs and violent moves down which ultimately lead the broader markets in a big circle. Contrary to popular belief, these are not periods in which the broad economy is in a prolonged malaise. Instead, these are periods where market participants refuse to reward earnings growth with outsized gains in valuation and higher and higher P/E ratios. The cause of this is the tendency of markets to overshoot reasonable value. At which point, participants lose interest while they wait for reality to catch up with perception.

To illustrate, I’ve included a graph of the S&P 500 and its P/E ratio from 1900 to 2006 (courtesy of Bespokeinvest.typepad.com).

While the markets are on an upward path over the entire century, distinct periods of lagging appreciation can be found from 1933-1946 and 1966-1980 each of which followed bullish moves upwards in the decade or more before these trading ranges. Distinctly observable is a similar horizontal move beginning in 1999 which followed an unprecedentedly long bull run from 1982-1999.

These trading ranges are not marked only by a lack of nominal appreciation in the broad markets, but also by compression of P/Es well into the single digits after bullish trends brought overall P/E ratios well above average. Historically, the average P/E of the S&P sits near 15. Not surprisingly, trading ranges and secular bear markets often started when P/Es reached 25 and did not end until P/Es had corrected into the single digits.  There’s no reason to believe we won’t see this again. At the very least, we know that despite corrections and continued earnings growth since 2000, S&P P/E ratios remain above historical norms, hovering around 17.

It’s not my intention to attempt to predict the direction of the markets going forward. This is often a fruitless task and even the most intelligent analysts make the wrong calls. Instead, I’m merely trying to draw your attention to the fact that despite the “correction” we’ve experienced of late, P/E contraction remains a significant risk to any long-term investment you enter. It is times like these when a focus on value and quality are most important. The good news is that it’s corrections like the one we’ve recently experienced which provide opportunities to find stocks offering true value as they punish all stocks – over valued and undervalued – indiscriminately.