I noted in a prior blog that the Fed is likely the major factor behind the current rally. Does the Fed trump analytics over the longer term? That is a question that many of my fellow analysts and Portfolio Manager colleagues have been discussing lately.
The above charts illustrate the forward returns of the S&P 500 based on current PE ratios. The top chart illustrates 10 year average returns on that index if you start off investing (buy and hold strategy) when the PE is at certain levels. The bottom illustrates 1 year historic average returns. For example: The current forward PE ratio (consensus) is around 21. Historic performance suggests a return of a small loss to a small gain for the coming 10 year period based on the current PE. One year historic return might fall between about – 20% to + 20% in the next 12 months – which makes sense given the more random statistics that occur within a shorter history. Its only over a longer period that we can spot “tenancies”
I’m not a CFA (Craig Aucoin in our office is a CFA) and this is a Technical blog. But….From what I see, this chart might imply that the Fed can push the markets up over the next year. This, so long as it keeps the flow going. Past performance has been up to 20% gains in a year when the P/E > 21. But, that Fed-flow isn’t going to last forever. The 10-year performance chart shows poor longer termed stock market performance given current P/E valuations.
The effective outlook (if you want to use this historic study as your guide) is near “0” average returns for the SPX for the coming decade. The message that I take out of this chart is that the Fed can most certainly trump neartermed stock market returns. But it won’t be a “forever” thing. Perhaps when the Fed backs off, the coming decade will be ideal for those who trade rather than passively invest.
Sentiment
There are many tools beyond trend analysis that Technical Analysts use to spot forward – viewing stock market returns. One of them is sentiment, which can be a leading indicator. One such indicator I like is the Smart/ Dumb money indicator. This indicator tends to be pretty good at predicting bigger moves on the market.
In a nutshell, here is how the indicator is constructed:
“Smart Money”—comprises sophisticated traders such as commercial hedgers, institutional managers etc. Some smart money types are exceptionally “smart”. People like Warren Buffet and Bill Ackman come to mind. They lead the pack, even in this group of better than average investors. Some are a little less “smart” – like the folks at Long Term Capital and Aman Capital who, smart as they were, still made un-smart decisions. They ended up losing lots of money. But… as a group, the institutional managers are reliably “smart” money. The smart money group tends to buy low and sell high on average.
And these guys (are you smart fella’s really gonna catch that couch?):
Or this liberal arts student who tried engineering at Montreal‘s École Polytechnique in 2002 but dropped out in 2003.[7][8] then environmental geography at McGill University in 2004 & dropped out in 2005.[9][8][7] Does this camp counselor,[10] nightclub bouncer,[11][12][10] and snowboard instructor sound like a smart guy who could run a country?:
As always, my Trudeau digs are the price of admission for this otherwise free blog. Oh, and I don’t post sharp reprisals to my digs.
Anyhow–The smart/dumb indicator (courtesy sentimentrader.com) often gives advanced views when Smart and Dumb money are simultaneously at extreme opposing views of optimism (or pessimism). This gives us a heads up for major market movements. Note on the chart below the signals occurring at market peaks and troughs. The red line is “dumb” money, and the blue line is “smart”money.
The smart/dumb indicator isn’t yet in a place where its signalling an overdone market. But, its heading that way. Note the vast difference in current smart/dumb confidence directions. I guess my questions remain: Will the high PE ratio guide markets to remain contained? Will dumb money rule the stock market and not just Canadian politics?
These questions will be answered over the coming year. As the 1-year PE chart shows us, there can be wide dispersion in returns even when valuations are stretched. But over time…such things don’t last…
7 Comments
What should be the strategy in the short term?. ‘In the long run we are all dead’
Ha!
Well, truthfully in the long term we ARE all dead. But that’s biology for you!
Re the markets, the PE ratio is not the holy grail of prediction, but its a tendency. So I’d say that even if the markets do end up with subdued returns for several years (a reasonable potential for that to be the case) this does not imply you cant make money. Stock picking, sector rotation, sector ETF’s, commodities, rather than broad index investing is the strategy IMO.
Love the blog, got a chuckle from JT digs. Thank you for both.
Well, I guess the argument by his supporters would be that even if he wasn’t born with the last name of a famous PM, he’d still be qualified.
Lets say guy by the name of John Doe with a drama degree who dropped out of two courses with math in it, who hadn’t held a full time job beyond substitute teaching and snowboard instruction, and who spent years travelling the world like a playboy living off his daddy’s money with no need to work—yeah, that sounds like a good candidate for a G-7 country leader. Vote John Doe.
not need to apologize for the “Justie” dig- hit the nail square on the pointed head. He is truly the dumbest guy on Canadian soil and I still can’t believe he got the job..2X.. UN-believable- good thing he has is drama degree..anyway, I think we have to dollar cost average until November – too much money and algorithms controlling the market – we are over valued and still waiting for green light from analysts- that’s when I am selling.. everybody wants a bear… I don’t think that’s in the cards until they declare “everything’s all good..” then you might see the drop that we are all waiting for…
Good point about the crowd behavior. I’ve learned more about market manipulation in the past 2 months than I had in the prior 30 years in this business.
Trump is right on this one it looks like there’s an economic boom coming. Post covid boom