Leading Valuation Indicators Flash Red For Equities

Leading Indicators Flashing Red On Equities

Stocks have posted a smart recovery from October’s -9.9% correction in equities and the market has run to new historic highs. This blog has written several articles in the past year highlighting that the fuel for the bull rally in equities has almost been exclusively driven by aggressive corporate buyback programs. We have also been very clear to point out that from a price-to-earnings (P/E ratio) standpoint, however, stock valuations are at comfortable long term “average” of 16X forward earnings. The widely followed P/E ratio says that as a group stocks are fairly valued.

That being said, there are several other measures of stock valuation that are equally informative that are flashing red as the SPX nears 2,075-2,100. The price-to-cash flow model of stock valuation suggests that quities both in the US and Europe as rather pricey. Similar price-to-cash flow valuations were an early warning prior to a 20% correction in 1998 and two 50+% corrections in equities beginning in 2000 and 2007.

The next valuation chart comes courtesy of Yale economics professor and Nobel laureate James Tobin. Professor Tobin won a Nobel prize for hypothesizing 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. With the exception of the "tech bubble" we are near the peak of every major bull market in history. The Q-ratio also closely correlates with one of Warren Buffet’s favorite measures of valuation, GDP- to-market capitalization.

The next chart is the Wilshire 5000 stock index market capitalization relative to GDP. During the past 115 years it has been fairly rare when this ratio exceeds 1.0. When it does, however, it has been a reliable indicator that there is trouble on the horizon for stocks. Warren Buffet has referred to this ratio as the single most-important measure of stock valuations.

Another historical warning signal for equities is when the performance of high-yield bond markets diverges from that of the broad stock market. The best way to illustrate divergences between the performance of stocks and high yield bonds is to show charts of when these two asset classes diverged in the past.

In 1998, equities were rallying hard, but US HY spreads failed to print new lows. Instead, they started widening in late 1997. Credit was telling us back then that Asia and Russia were severely slowing down while corporate balance sheet health was deteriorating. It preceded the 1998 crash.

In 1999/2000, the divergence was even more pronounced. The S&P500 not only recovered from the Asian crisis but rallied strongly during the Tech bubble. US HY spreads had bottomed 3 years earlier! Corporate balance sheets were at the time very stretched. As a result, banks were tightening lending standards. The equity market eventually crashed, tracking the signal sent by widening credit spreads.

During 2007/2008, credit spreads bottomed in May 2007 and started widening immediately after, while equities kept moving higher for another 5 months (October 2007). Spreads were telling us just like in 2000 that private sector leverage had reach such an elevated level that banks were starting to close the credit flows. Again, the divergence timed the bear market that followed.

In 2008/2009, spreads topped out in December while equities made new lows that were not confirmed by a new high on HY spreads. At that time, corporate balance sheet had started to adjust violently to the crisis. Capex had been cut to zero, the corporate sector was issuing equity (net positive liquidity impact) and cash flows had already bottomed and were starting to rise. Balance sheet health was improving, as evidenced by tightening credit spreads. The bullish divergence timed the end of the bear market.

In 2011, spreads bottomed in February while equities made a new high in April, as spreads widened further due to the European sovereign crisis. Equities reversed shortly after.

Today, the divergence is visible again. US High Yield spreads bottomed in June and have widened substantially since then. Equities are still printing new highs. Are US HY spreads telling us that global growth is weaker than expected, a message also sent by flattening yield curves, depressed bond yields, defensive massive outperformance relative to cyclicals. Is it Europe? Russia? Emerging Markets?

And "complacency" in the financial markets is also at levels that have had poor future outcomes. The VIX index is the market’s expectation for 1-month volatility of at-the-money options in the S&P 500 stock index. When forecast/implied volatility (as measured by the VIX, is low), investors are perceived to be complacent about risk. When implied volatility is high, investors are perceived to be too pessimistic about risk. Tops in stocks tend to occur during periods of investor complacency while bottoms emerge during periods of high investor anxiety.

Conclusions

The leading valuation measures of stock valuations in this blog post paint a fairly pessimistic view of stock returns from current levels (about 2,070 in the SPX). Does it mean that investors should liquidate their stock holdings today or buy puts today? No, probably not. These valuation measures can linger at over-extended levels for some time before stock prices turn in the other direction. The principal bull argument for equities is that investment returns to stock alternatives is poor. Therefore, the best chance of getting a positive return is still in equities. It is difficult to argue with this logic, but it also no guaranty that equity prices will continue to push higher either.

I suspect that the SPX can trade up to 2,080-2,100 in the near term but risk is growing for a larger correction of 15%-20% back toward 1,700 in the next 4-6 months. Such a shakeout would be counter-seasonal and very out of the ordinary. The catalyst for such a sell-off is not readily apparent yet. Maybe it will reveal itself as the SPX nears 2,100 or perhaps not. As a result I’m not buying puts yet but I’ll be scrutinizing the day-to-day price action with a much more discerning eye as 2,100 nears.