As the S&P 500 gradually drifts lower in 2008, many analysts and portfolio managers are now saying the index has attractive valuations and are offering investors excellent profit opportunities. But is the S&P 500 really cheap at present levels? And are these recent short-term rallies just a bull trap?

But first, what is a bull trap? It is a false signal indicating that a declining trend in a stock or index has reversed and is starting to head upwards (and providing investors with a sense of false optimism) when in fact, the security is continuing to fall. A bull trap often causes some investors to buy securities at seemingly good valuations and price levels but because the main trend is still down, the stock continues to decline after the initial short-term upward “bull movement.” Those who bought in are "trapped" in a bad investment.

Though the S&P 500 appears attractive technically, these short-term rallies up to 1400 from February to early April can be considered a bull trap. Technical models (lower portion of Chart 1 above) indicates that increasing downward pressure should begin to build in May and June.

And what about fundamentally? Is the S&P 500 really offering attractive valuations now? Certainly not according to the fathers of value buying. Chart 2 (above) shows Graham and Dodd's formula for judging long-term valuations. Only during the technology bubble in 2000 was the S&P 500 more overvalued. At current levels (Chart 3 below) the index has a P/E of 19.87. Fair value (P/E 15) would be at 993. This would suggest the S&P 500 needs to decline 25% to equal that amount. Undervalued (P/E 10) would be at 662, or 50% lower than the present level.

Bottom line: The S&P 500 is currently expensive when evaluated for normal P/E. A price level 300 points lower then the present 1300 would make the benchmark index only fair value. The current over valuation of the S&P 500 increases downside risk.

Investment approach: History indicates that overvalued indexes in bear markets are especially susceptible to downward pressure and lower numbers. Investors may wish to limit any purchases of S&P 500 stocks until the index has at lest drifted down to fair value. This would be at about 993. Alternatively, investors can profit from the anticipated decline by purchasing bear ETFs on the S&P 500. The Short S&P 500 ProShares (AMEX: SH, Bullboard) provides upward movement when the S&P 500 falls.

More research on the S&P 500 and other North American stock indexes can be found in the April newsletter. Go to www.technicalspeculator.com and click on member login.

Your comments are always welcomed.

Donald W. Dony FCSI, MFTA