Weekly Update

Long-term Models and Metrics Can Lead to Misreading the Market


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Published August 4, 2017

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There are a number of folks talking about how overvalued this stock market is. Many of them refer to the metrics, indicators, and models discussed below. Read through this analysis from Jill Mislinski and we will return for some perspective at the end.

“Here is a summary of the four market valuation indicators we update on a monthly basis.
• The Crestmont Research P/E Ratio
• The cyclical P/E ratio using the trailing 10-year earnings as the divisor
• The Q Ratio, which is the total price of the market divided by its replacement cost
• The relationship of the S&P Composite price to a regression trendline

To facilitate comparisons, we’ve adjusted the two P/E ratios and Q Ratio to their arithmetic means and the inflation-adjusted S&P Composite to its exponential regression. Thus the percentages on the vertical axis show the over/undervaluation as a percent above mean value, which we’re using as a surrogate for fair value. Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 58% to 116%, depending on the indicator, up from the previous month’s 55% to 115%.

We’ve plotted the S&P regression data as an area chart type rather than a line to make the comparisons a bit easier to read. It also reinforces the difference between the line charts — which are simple ratios — and the regression series, which measures the distance from an exponential regression on a log chart.

Q Ratio and P/E10 Adjusted to Their Arithmetic Means with the Real S&P Composite Regression to Trend

The chart below differs from the one above in that the two valuation ratios (P/E and Q) are adjusted to their geometric mean rather than their arithmetic mean (which is what most people think of as the “average”). The geometric mean increases our attention to outliers. In our view, the first chart does a satisfactory job of illustrating these four approaches to market valuation, but we’ve included the geometric variant as an interesting alternative view for the two P/Es and Q. In this chart, the range of overvaluation would be in the range of 70% to 130%, up from last month’s 67% to 129%.

Q Ratio and P/E10 Adjusted to Their Geometric Means with the Real S&P Composite Regression to Trend

The Average of the Four Valuation Indicators

The next chart gives a simplified summary of valuations by plotting the average of the four arithmetic series (the first chart above) along with the standard deviations above and below the mean.
At the end of last month, the average of the four is 89% — unchanged from the previous month and at the interim peak.

Average of the Four Valuation Indicators

Here is the same chart, this time with the geometric mean and deviations. The latest value of 99% was also unchanged from last month and at its interim peak.

Average of the Four Valuation Indicators (Geometric)

As we’ve frequently pointed out, these indicators aren’t useful as short-term signals of market direction. Periods of over- and under-valuation can last for many years. But they can play a role in framing longer-term expectations of investment returns. At present, market overvaluation continues to suggest a cautious long-term outlook and guarded expectations. However, at today’s low annualized inflation rate and the extremely poor return on fixed income investments (Treasuries, CDs, etc.) the appeal of equities, despite overvaluation risk, is not surprising.

Market Valuation and Actual Subsequent 10-Year Total Returns

Many of our readers have requested we reproduce a chart by John Hussman that inverts the S&P 10-year total returns. Hussman says “the most reliable correlation between valuations and subsequent returns is on a 12-year horizon, which is the point where the autocorrelation profile of valuations typically hits zero.” The correlation of valuations Hussman uses for comparison are at about 90%.

You will notice that nominal returns are used – this is a direct result of a sort of Fisher-effect in which inflation ends up being washed out of the calculation. The nominal growth rate of the economy is highly correlated with the level of interest rates, but also negatively correlated with market valuations, all over the same time period.

Here are the Geometric Average of the Four again and the recreated Hussman charts together.

Average of the Four Valuation Indicators (Geometric)10-year Nominal Total Return

Points of ‘secular’ undervaluation such as 1922, 1932, 1949, 1974 and 1982 typically occurred about 50% below historical mean valuations, and were associated with subsequent 10-year nominal total returns approaching 20% annually. By contrast, valuations similar to 1929, 1965 and 2000 were followed by weak or negative total returns over the following decade. That’s the range where we find ourselves today. Of course, we also won’t be surprised if the S&P 500 ends up posting weak or negative total returns in the 2007-2017 decade, which would require nothing but a run-of-the-mill bear market over the next couple of years. – John Hussman

Ok. Thanks Jill. We are back. As Jill mentions, these long-term measures of stock market value can lead you to under or over-investing for years at a time. They are best used as a background concept to explore extremes in valuation. For example, the chart above would have suggested that your expected future return for stocks in 2009 would have been low single-digits. That might have pushed you to invest more heavily in bonds, which would have worked out fine. But stocks have gone on, since 2009, to post solid double-digit returns. They’ve outperformed bonds handily. To be sure, buying stocks in 1982 when the above chart notes that future returns were expected to be almost 20% would have been great. Likewise, selling stocks in 2000 would have been good also. But any metric that is averaging over a 10-year period is going to be slow to move and thereby cause you to be holding firm to whatever that model is saying for an extended period of time. The above-mentioned John Hussman, a noted money manager, has dramatically underperformed in the rally since 2009. He’s held tightly to his notion that this rally has been on a weak fundamental foundation and, using the above metrics/models, has almost entirely missed the rally. Indeed, just this week he posted another article reiterating how badly this all will end for investors. Here at TimingCube, we’ve got your back and will protect your investments from the downsides Mr. Hussman speaks of. It’s what we do! BUT, we also have participated in the rally from 2009. People focused on the above long-term models have largely missed it.

For Mr. Hussman’s latest weekly blog post go here:

https://www.hussmanfunds.com/wmc/wmc170731.htm


Market Update

A solid month of July for stocks of the large-cap variety came to an end Monday in a flat session for the broad market while the Nasdaq gave back some of the months’ gains. Investors on Tuesday managed to overcome weakness in some industrial names like Cummins (CMI) to close up +0.2%. Apple’s results surprised to the upside to send the company’s shares higher Wednesday by over +4% and keep stock indexes from what would have otherwise been a losing session. Strong results from health insurer Aetna (AET) and electric car maker Tesla (TSLA) offset another day of modest weakness in stocks overall Thursday. Large-caps kept losses to a slim -0.2% while small-cap stocks tumbled almost -1% for a second consecutive day. The contrast between the mostly domestic-focused small-cap stocks and more globally-oriented large-caps was a theme this week. The monthly employment report highlighted Friday’s trade with another solid reading though wage growth remains tepid. Stocks added +0.2% on the day while Treasury yields popped higher.

For the week, small-cap (IWM) stocks fell -1.23% while the large-cap S&P 500 (SPY) was flat with a +0.19% move. The Nasdaq 100 (QQQ) digested its recent gains with a sideways -0.13% move. It’s noteworthy that international stocks rose +1% for their fourth straight weekly gain.

Warm wishes and until next week.