In January, I did a chart analysis of the markets suggesting that being overly optimistic going into 2015 could be dangerous.
“As we enter into 2015, analyst calls for a continued “bull market” advance have never been louder. There have been a litany of articles written recently discussing how the stock market is set for a continued bull rally. The are some primary points that are common threads among each of these articles which are: 1) interest rates are low, 2) corporate profitability is high, and; 3) the Fed’s monetary programs continue to put a floor under stocks. The problem is that while I do not disagree with any of those points – they are all artificially influenced by outside factors. Interest rates are low because of the Federal Reserve’s actions, and corporate profitability is high due to accounting rule changes following the financial crisis. Lastly, the Fed’s liquidity program artificially inflated stock prices.
While the media continues to pound the table with all of the bullish arguments that should continue to drive the current advance in the markets, it is only prudent to at least attempt an understanding of the counter arguments. The “risk” to investors is not a continued rise in the financial markets, but the eventual reversion that will occur. Like Wyle E. Coyote, since most individuals only consider the “bull case,” as it creates a confirmation bias to support their “greed factor”, they never see the “cliff” until it is far to late.”
As we end the third quarter of the year, those warnings have come to pass. However, the debate that began this year remains – are we still within an ongoing multi-year bull market OR has the next cyclical bear market taken hold?
The series of charts below is designed to allow you to draw your own conclusions. I have only included commentary where necessary to clarify chart construction or analysis.
If you have any questions, or comments, send me a tweet: @lanceroberts
The following chart shows Tobin’s “Q” ratio and Robert Shiller’s “Cyclically Adjusted P/E (CAPE)” ratio versus the S&P 500. James Tobin of Yale University, Nobel laureate in economics, hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs.
The Q ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets. Dr. Robert Shiller, also a Nobel Prize winning Yale professor, created CAPE to smooth earnings variations and volatility over time. CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive. Currently, the CAPE is at 25.5x, and the Q-ratio is at 1.02.
My friend Doug Short regularly publishes Ed Easterling’s valuation work. Ed Easterling, Crestmont Research, has done extensive studies on valuation and resulting long-term returns.
The next two charts are variants on Robert Shiller’s CAPE. The first is just a pure analysis of CAPE as compared to the S&P 500.
[For More On Shiller’s CAPE Debate read: “Is Shiller’s CAPE Really B.S.” and “Shiller’s CAPE, A Better Measure”]
The next chart shows the deviation of valuations from their long-term average.
Measures Versus The Economy
One of Warren Buffet’s favorite valuation measures is Market Cap to GDP. I have modified this analysis utilizing real, inflation-adjusted, S&P 500 market capitalization as compared to real GDP. I have also noted the long-term median level as well as the average since 1990.
Since the stock market should be a reflection of the underlying economy, then the amount of leverage, or margin debt, in the market as a percentage of GDP could provide an important clue.
The following charts are measures of deviation from underlying trends or averages. The greater the deviation from the long-term trends or averages; the greater the probability of a reversion back to, or beyond, those trends or averages.
The first chart is the 72-month rate of change in the price of the S&P 500 relative to the index itself. Large spikes in the rate of change have normally been seen prior to intermediate and long-term market peaks.
The next chart is the deviation in the price of both the S&P 500 and Wilshire 5000 from the 36-Month moving average. For more discussion on this chart read this.
The chart below is the same basic analysis but utilizing a 50-week moving average which is a more “real-time” variation. Importantly, note that historically when the market has significantly broken the 50-week moving average in the past, it has denoted a change in market trend.
This potential change in trend can be more clearly seen in the chart below. Note: The market has not currently broken the previous bullish trend line that begin in 2009, however, historically it has just been a function of time.
The volatility index (VIX) is representative of investors “fear” of a correction in the market. Low levels represent investor complacency and no fear of a market correction. Despite the recent correction to date, investor complacency remains elevated.
Just For Good Measure
I recently wrote about the importance of “record market highs” stating:
“…while markets have risen over time, the markets spend roughly 95% of their time making up for previous losses.”
And A Reminder
Recently, John Hussman tweeted this chart of the S&P 500 that lists all of the warnings signs of a crash that we are experiencing now.
“Anatomy of a textbook pre-crash bubble. Don’t rely on further blowoff, but don’t be shocked. Risk dominates. Hold tight.”
This analysis can tell us much about where we are within the current market cycle if we choose to pay attention. While it is certainly easy to bet on “hope,” it is important to remember that it is far harder to make up losses when things go wrong.
What has always separated successful professional gamblers from the “weekend sucker” is knowing when to step away from the table.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.