The major stock market indices have been moving in a volatile, back-and-forth, up-and-down fashion for three and one-half months now. For anyone attempting to stay in tune with the trend of the market, this has been a frustrating time as the S&P has changed direction no fewer than 9 times since the beginning of December.
Yet during this annoying period, the S&P 500 has made a total of 12 new all-time highs, the NASDAQ moved back above the 5,000 level (albeit only briefly), and even last year's much-maligned small caps reached fresh all-time highs. The problem is that the moves to new highs were not met with follow-through buying or a new leg higher. As such, the current trend among the fast-money types is to greet each new high with selling.
While the bears have clearly prevented the bulls from gaining any meaningful ground, our furry friends remain frustrated as well. You see, despite all the volatility and all the big down days seen this year, the S&P 500 closed Friday just 3% below the most recent all-time high set on March 2.
In short, both teams have had opportunities. And yet both teams have failed to get anything done. Thus, the obvious question is, why?
For Every Plus There Is a Minus...
To hear the bears tell it, their problem is that every time they get something going to the downside, some central bank announces plans to print a whole boatload of new money. Therefore, the big banks, hedge funds etc. able to participate in various carry trades continue to play on. And then the dip-buyers come in with the knowledge that at least some of those new yen and euros being printed will wind up in the U.S. stock (and bond) market.
On the other side of the court, our heroes in horns continue to struggle as well. The problems the bulls face include (a) a surging dollar, (b) falling earnings expectations, (c) a Fed that threatens to become a little less friendly in the next few months, and (d) valuations that are no longer a positive.
So there you have it; every plus has been met with a minus recently and vice versa. And the end result is a manic/depressive market that can't move in any one direction for even a month at a time.
Are Valuations Really a Problem?
The bears contend that valuations are becoming a problem. By now, everyone has seen Dr. Shiller's CAPE index and the dire warning it provides. However, valuation is a VERY tricky subject as there are many different metrics to consider and just as many ways to view the data.
So, in an effort to determine if valuations are indeed the problem that our friends in the bear camp contend, we thought we would take a look at a couple P/E ratios, the Price-to-Sales, Dividend, and Book Value ratios, as well as a model that looks at stock market values relative to interest rates.
So, let's get started...
First up is the Median Price-to-Earnings Ratio. For this calculation, we use the S&P 500's median P/E on a 12-month trailing basis. Such an approach attempts to smooth things out by focusing on the median earnings within the index.
Take a look at the chart of this indicator below. The first point to understand is that what was overvalued in the 1960's, 70's, and early 80's is no longer an overvalued reading. No, since 1990, the levels have clearly shifted.
S&P 500 Median Price-to-Earnings Ratio
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The second point to consider is that the period within the blue box was clearly a bubble. As such, it is probably best to assume that the readings seen between 1999 and 2003 were outliers.
So, if we remove the bubble readings, we can draw in the "overvalued line" at about the 22 level and the "undervalued" extreme down around 13. And we can argue that the green dashed line, which represents the median reading back to 1964, is now the mid-point of the range of P/E valuations seen since 1990.
Using these assumptions, the takeaway is that stocks are now very close to what has been considered overvalued over the past 25 years. Advantage Bears.
Next, let's take a look at the S&P's P/E ratio using GAAP (generally accepted accounting principles) earnings. We like this approach due to the fact that GAAP earnings remove a lot of the games that companies play in order to puff up their reports. In short, we consider GAAP earnings to be a "Just the facts Ma'am" approach.
S&P 500 Price-to-Earnings Ratio (GAAP Earnings)
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The current reading for this ratio is 20.57 as of the end of February. This is below the 25-year average of 25.18, above the 50-year average of 19.20 and also above the full period (89 years) average of 17.01. Therefore, the bulls argue that this measure of valuation is not a problem at this point.
Yet, as the chart clearly illustrates, there are two periods over that last 89 years that should likely be considered outliers - the 2000 technology bubble period and the "credit crisis" of 2008-09.
Thus, if we are going to be objective, it is probably a good idea to toss out those two periods. In doing so, it appears that readings somewhere in the vicinity of 20-23 can be considered "expensive." And with a current reading at 20.57, it is very hard to argue that stocks are anything but extended at this time. Therefore, this indicator can also be put in the bear's column.
There are Other Metrics Besides Earnings
While P/E ratios represent much of the focus in this arena, investors need to understand that we have been living in an era of "financial engineering" for some time now. This means that earnings really aren't a pure measurement due to things like stock buybacks, etc. Therefore, it only makes sense to look at other valuation metrics including Price-to-Sales, Price-to-Dividend, and Price-to-Book Value ratios.
S&P Industrial Price-to-Sales Ratio
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At first blush, the Price-to-Sales chart of the S&P appears to be utterly useless. Over the past 60+ years, there have been what appears to be three distinctly different eras in the market.
From 1954 through the mid-1970's, the Price-to-Sales ratio stayed in a very definable range and it was easy to determine when stocks were expensive/cheap using this measure. But then the secular bear market hit, and suddenly what had been considered "cheap" for 20 years wound up getting a lot cheaper.
Enter the next era of this indicator. For the next 20 years, the lines of demarcation for over/undervaluation were dramatically different. And then just to show how difficult the valuation game can be, things changed again - dramatically - starting in 1995.
So, if we focus our attention on the current era (the last 20 years) the picture becomes a little clearer. However, we still have the "bubble" valuations of 2000 to deal with. Whether or not you decide to toss out the 2000 levels, the bottom line is that stocks are clearly NOT cheap by this metric. So, yep, you guessed it; this indicator also favors the bears.
Next up is the Price-to-Dividend Ratio.
S&P 500 Price-to-Dividend Ratio
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As was the case with the Price-to-Sales ratio, there are three distinctly different "eras" to be seen on the P/D chart. There was one range seen from 1925 through the mid-1950's, another from 1957 through 1995, and yet another since 1995. (BTW, is the theme that the valuation game changed in 1995 becoming apparent yet?)
The next problem with the P/D ratio is the change in corporate behavior in this "new era." The bottom line is that companies have focused more on stock buybacks than on paying dividends. And because of this, the ratio has become quite skewed.
And then once again, there is the bubble period to deal with as valuations of all shapes and sizes simply got out of whack with historical levels.
So, what is the takeaway from the P/D? First, the "financially engineering" era has skewed this ratio rather severely. As such, we don't put much emphasis on this particular measure of value. However, once again, it is hard to argue that the stock market is anything but extended by this ratio.
And speaking of metrics that have gotten out of whack, let's now turn to the Price-to-Book ratio.
S&P 500 Price-to-Book Ratio
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At first glance, this indicator also appears to provide little help in determining whether or not stocks are overvalued. The problem is that the P/B ratio moved steadily higher from the early 1980's through the tech bubble of 2000 and then moved straight down into 2003.
And while our view can be considered more art than science, we will argue that there actually has been a fairly definable range of the P/B ratio over the last 10-15 years. Yes, the ratio got out of whack to the downside during the crisis in 2008-09. However, since 2002, the range has been fairly steady.
Although there are not a lot of data points to work with here, it does appear that the high end of the P/B range since 2002 has been about 3.0, while the low end (excluding the crisis period) has been around 1.9. So, with the current reading at 2.6, we can argue that while the P/B may not horribly expensive, it also is a far cry from cheap.
Thus, an objective analysis suggests that like the P/E, P/S, and P/D, the P/B is also extended at this point in time. And yes, this is another check mark in the bear column.
But Remember, Things Don't Matter Until They Do...
To be sure, the bears have a case here as all of the primary valuation metrics are either already in overvalued territory or on the cusp. So, is this a reason to head for the hills? Is it time to take less risk in your stock portfolio or start hedging?
In a word, no.
You see, in the stock market, something like valuation doesn't matter on a day-to-day basis... until it does, of course! The trick then is to determine when valuations might become an overhang on the market.
The next valuation indicator actually sums up the situation nicely.
Valuation Model: Price Relative to Interest Rate Environment
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In looking at the chart above, it is important to first recognize that the under/overvaluation zones are reversed compared to the other charts. Higher readings represent undervaluation while lower readings represent overvaluation. This is due to the fact that the model compares price to a host of interest rate yields.
This model compares the weekly price of the S&P 500 to the 10-year averages of earnings yields, dividend yields, book value yields, real earnings yields, real dividend yields, and then the spreads between the yields of earnings and bonds, and dividends and bonds. In other words, the price of the S&P 500 is being compared to all kinds of yields available in the market.
As you can see, the current reading is SOLIDLY in the "undervalued" zone.
How can this be, you ask? Aren't all the other indicators pointing to the stock market being overvalued?
The explanation here is simple. When compared to the current level of interest rates and yields on competing instruments, stocks are cheap on a historical basis.
And in our humble opinion, THIS is the key to the current valuation debate. Yes, stocks are overvalued by historical standards using traditional metrics. There is no argument here. However, given that rates around the world are so low, stocks continue to represent RELATIVE bargains!
The bottom line is that unless/until the central banks of the world stop printing trillions of yen/euros each year - or until the U.S. economy really starts to kick into gear (which would likely trigger inflation) - it is this RELATIVE valuation story that is likely to dominate the action.
Put another way, until the current era of central bank intervention comes to a close, stocks are likely to represent a solid alternative for new money.
So... are stocks overvalued using traditional metrics? Yes, there is no denying the facts. However, the question is: Does it matter? And the answer is that until the central bankers stop printing money, probably not.
Turning to This Morning...
The primary talking points on this fine Monday morning include the resumption of Oil's decline, the expectation for a verbiage change when the Fed meets this week, and word that China's Premier is talking about cutting rates in order to support job growth. On the latter topic, Premier Li talked up China’s "policy flexibility" saying that Beijing could support the economy on a broad scale basis if growth risked breaching “lower limit” or threatened employment and income gains. This statement was the biggest signal yet that more rate cuts are coming in China. Chinese stocks rallied nicely with Shanghai gaining more than 2% overnight. Here in the U.S. the focus remains on the removal of the word "patient" from the FOMC statement on Wednesday. Also note that this meeting will include a quarterly press conference with Ms. Yellen. U.S. stock futures point to a stronger open at this time.
Here are the Pre-Market indicators we review each morning before the opening bell...
Major Foreign Markets:
Hong Kong: +0.53%
Crude Oil Futures: -$0.48 to $44.36
Gold: +$4.50 at $1156.90
Dollar: lower against the yen and pound, higher vs. euro
10-Year Bond Yield: Currently trading at 2.096%
Stock Indices in U.S. (relative to fair value):
S&P 500: +6.85
Dow Jones Industrial Average: +64
NASDAQ Composite: +13.35
Thought For The Day:
Accept what is, let go of what was, and have faith in what will be. -Unknown
Current Market Drivers
We strive to identify the driving forces behind the market action on a daily basis. The thinking is that if we can both identify and understand why stocks are doing what they are doing on a short-term basis; we are not likely to be surprised/blind-sided by a big move. Listed below are what we believe to be the driving forces of the current market (Listed in order of importance).
1. The State of Fed/ECB Policy
2. The State of the U.S. Economy
3. The State of the U.S. Dollar
The State of the Trend
We believe it is important to analyze the market using multiple time-frames. We define short-term as 3 days to 3 weeks, intermediate-term as 3 weeks to 3 months, and long-term as 3 months or more. Below are our current ratings of the three primary trends:
Short-Term Trend: Negative
(Chart below is S&P 500 daily over past 1 month)
Intermediate-Term Trend: Moderately Positive
(Chart below is S&P 500 daily over past 6 months)
Long-Term Trend: Positive
(Chart below is S&P 500 daily over past 2 years)
Key Technical Areas:
Traders as well as computerized algorithms are generally keenly aware of the important technical levels on the charts from a short-term basis. Below are the levels we deem important to watch today:
- Key Near-Term Support Zone(s) for S&P 500: 2040
- Key Near-Term Resistance Zone(s): 2100
The State of the Tape
Momentum indicators are designed to tell us about the technical health of a trend - I.E. if there is any "oomph" behind the move. Below are a handful of our favorite indicators relating to the market's "mo"...
- Trend and Breadth Confirmation Indicator (Short-Term): Neutral
- Price Thrust Indicator: Negative
- Volume Thrust Indicator: Negative
- Breadth Thrust Indicator: Neutral
- Bull/Bear Volume Relationship: Positive
- Technical Health of 100 Industry Groups: Neutral
The Early Warning Indicators
Markets travel in cycles. Thus we must constantly be on the lookout for changes in the direction of the trend. Looking at market sentiment and the overbought/sold conditions can provide "early warning signs" that a trend change may be near.
- S&P 500 Overbought/Oversold Conditions:
- Short-Term: Oversold
- Intermediate-Term: Neutral
- Market Sentiment: Our primary sentiment model is Negative .
The State of the Market Environment
One of the keys to long-term success in the stock market is stay in tune with the market's "big picture" environment in terms of risk versus reward.
- Weekly Market Environment Model Reading: Neutral
Wishing you green screens and all the best for a great day,
David D. Moenning
Founder and Chief Investment Strategist
Heritage Capital Research
Trend and Breadth Confirmation Indicator (Short-Term) Explained: History shows the most reliable market moves tend to occur when the breadth indices are in gear with the major market averages. When the breadth measures diverge, investors should take note that a trend reversal may be at hand. This indicator incorporates an All-Cap Dollar Weighted Equity Series and A/D Line. From 1998, when the A/D line is above its 5-day smoothing and the All-Cap Equal Weighted Equity Series is above its 25-day smoothing, the equity index has gained at a rate of +32.5% per year. When one of the indicators is above its smoothing, the equity index has gained at a rate of +13.3% per year. And when both are below, the equity index has lost +23.6% per year.
Price Thrust Indicator Explained: This indicator measures the 3-day rate of change of the Value Line Composite relative to the standard deviation of the 30-day average. When the Value Line's 3-day rate of change have moved above 0.5 standard deviation of the 30-day average ROC, a "thrust" occurs and since 2000, the Value Line Composite has gained ground at a rate of +20.6% per year. When the indicator is below 0.5 standard deviation of the 30-day, the Value Line has lost ground at a rate of -10.0% per year. And when neutral, the Value Line has gained at a rate of +5.9% per year.
Volume Thrust Indicator Explained: This indicator uses NASDAQ volume data to indicate bullish and bearish conditions for the NASDAQ Composite Index. The indicator plots the ratio of the 10-day total of NASDAQ daily advancing volume (i.e., the total volume traded in stocks which rose in price each day) to the 10-day total of daily declining volume (volume traded in stocks which fell each day). This ratio indicates when advancing stocks are attracting the majority of the volume (readings above 1.0) and when declining stocks are seeing the heaviest trading (readings below 1.0). This indicator thus supports the case that a rising market supported by heavier volume in the advancing issues tends to be the most bullish condition, while a declining market with downside volume dominating confirms bearish conditions. When in a positive mode, the NASDAQ Composite has gained at a rate of +38.3% per year, When neutral, the NASDAQ has gained at a rate of +13.3% per year. And when negative, the NASDAQ has lost at a rate of -8.5% per year.
Breadth Thrust Indicator Explained: This indicator uses the number of NASDAQ-listed stocks advancing and declining to indicate bullish or bearish breadth conditions for the NASDAQ Composite. The indicator plots the ratio of the 10-day total of the number of stocks rising on the NASDAQ each day to the 10-day total of the number of stocks declining each day. Using 10-day totals smooths the random daily fluctuations and gives indications on an intermediate-term basis. As expected, the NASDAQ Composite performs much better when the 10-day A/D ratio is high (strong breadth) and worse when the indicator is in its lower mode (weak breadth). The most bullish conditions for the NASDAQ when the 10-day A/D indicator is not only high, but has recently posted an extreme high reading and thus indicated a thrust of upside momentum. Bearish conditions are confirmed when the indicator is low and has recently signaled a downside breadth thrust. In positive mode, the NASDAQ has gained at a rate of +22.1% per year since 1981. In a neutral mode, the NASDAQ has gained at a rate of +14.5% per year. And when in a negative mode, the NASDAQ has lost at a rate of -6.4% per year.
Bull/Bear Volume Relationship Explained: This indicator plots both "supply" and "demand" volume lines. When the Demand Volume line is above the Supply Volume line, the indicator is bullish. From 1981, the stock market has gained at an average annual rate of +11.7% per year when in a bullish mode. When the Demand Volume line is below the Supply Volume line, the indicator is bearish. When the indicator has been bearish, the market has lost ground at a rate of -6.1% per year.
Technical Health of 100 Industry Groups Explained: Designed to provide a reading on the technical health of the overall market, this indicator takes the technical temperature of more than 100 industry sectors each week. Looking back to early 1980, when the model is rated as "positive," the S&P has averaged returns in excess of 23% per year. When the model carries a "neutral" reading, the S&P has returned over 11% per year. But when the model is rated "negative," stocks fall by more than -13% a year on average.
Weekly State of the Market Model Reading Explained:Different market environments require different investing strategies. To help us identify the current environment, we look to our longer-term State of the Market Model. This model is designed to tell us when risk factors are high, low, or uncertain. In short, this longer-term oriented, weekly model tells us whether the odds favor the bulls, bears, or neither team.
The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program.
Any investment decisions must in all cases be made by the reader or by his or her investment adviser. Do NOT ever purchase any security without doing sufficient research. There is no guarantee that the investment objectives outlined will actually come to pass. All opinions expressed herein are subject to change without notice. Neither the editor, employees, nor any of their affiliates shall have any liability for any loss sustained by anyone who has relied on the information provided.
The analysis provided is based on both technical and fundamental research and is provided “as is” without warranty of any kind, either expressed or implied. Although the information contained is derived from sources which are believed to be reliable, they cannot be guaranteed.
David D. Moenning, an advisor representative of CONCERT Wealth Management Inc. (CONCERT), is founder of Heritage Capital Advisors LLC, a legal business entity doing business as Heritage Capital Research (Heritage). Advisory services are offered through CONCERT Wealth Management, Inc., a registered investment advisor. For a complete description of investment risks, fees and services review the CONCERT firm brochure (ADV Part 2) which is available from your Investment Representative or by contacting Heritage or CONCERT.
Mr. Moenning is also the owner of Heritage Capital Management (HCM) a state-registered investment adviser. HCM also serves as a sub-advisor to other investment advisory firms. Neither HCM, Heritage, or CONCERT is registered as a broker-dealer.
Employees and affiliates of Heritage and HCM may at times have positions in the securities referred to and may make purchases or sales of these securities while publications are in circulation. Editors will indicate whether they or Heritage/HCM has a position in stocks or other securities mentioned in any publication. The disclosures will be accurate as of the time of publication and may change thereafter without notice.
Investments in equities carry an inherent element of risk including the potential for significant loss of principal. Past performance is not an indication of future results.