My apologies to those who take offence at the use of the “F” word. You know what I’m talking about – Fundamental Analysis. But my friend Craig Basinger, Chief Investment Officer at Macquarie (soon to be Richardson GMP) was kind enough to forward an interesting chart to me – and I think it’s worth your time to see it. Craig tells me he cribbed the idea from S&P research. Whatever the case, the chart below shows us various “ghost lines” of where the S&P 500 would be sitting, given various PE ratios . The S&P 500 is currently sitting at about 15 times forward earnings based on bottom-up estimates of operating earnings. The thicker line is the S&P 500, and the thinner coloured lines represent various PE multiples. Looking at a long history, the average PE ratio for the S&P 500 dating back to the mid-1930s is about 16. This implies that the S&P can actually advance by 1-2 times earnings from where it is right now over the coming months.
Work by Ross Healy of Strategic Analysis Corp. (www.strategicanalysis.ca) shows a similar potential when looking at book value breakouts. Ross has created “ghost lines” surrounding both stocks and indices for years – only he is using various breakouts of Price/Book Value (P/B) rather than P/E ratios. Note on the S&P chart that P/B is hovering around what Ross calls the “growth rate”—which is effectively 2x P/B. His work shows that markets can and often will drive prices into the 2.5x P/B. This, according to Ross, gives the S&P 500 about 10% in potential upside from here.
Ross has also kindly provided me with a chart of the TSX vs. its P/B breakout points. The TSX, according to Ross, rarely breaches much over 1.5x P/B. However, the recent chart breakout for the TSX composite gives it some potential to do so, perhaps reaching the S&P500’s level of 2x P/BV. I won’t hold my breath on that one—given my rather sour view of commodities markets going forward.
If you come to my MoneyShow presentation on Friday (9:15am), I’ll be highlighting some stocks to consider for the coming months -given the richer market valuations of late– as well as some to avoid. While this bull market is likely to see a significant correction eventually (perhaps some time later next year), the near termed outlook remains bullish. This is backed up by a reasonable expectation of a bit more multiple expansion, according to Mr. Basinger’s and Mr. Healy’s charts. The ‘F’s” and the “T’s” seem to be agreeing at this time.
12 Comments
Keith,
In regard to the PE of the S&P 500, what about the Shiller CAPE being quite high, around 24?
Brian–an excellent question!
The Shiller CAPE is very high indeed. But keep in mind that it can in fact hang out at this level for a while before the proverbial poop hits the fan. So, as I indicate in this and other blogs (see my recent observation of an expanding pattern on the S&P) – things are getting more expensive, but there is a little left in this trend yet. I just finished writing a column for Investors Digest, and I put it like this: “The hour is getting late for this stock party, but there is time for one last dance before everyone has to go home”. My thoughts are, based on seasonality and a cycle study that I will re-visit in a future blog (I covered a 5-yr cycle on this blog in the past)–we are due for a correction some time after Q1 or Q2 of 2014. BTW–this ties into my prior blogged observation of weak markets after each QE program ended.
Here is an excellent article summarizing the interpretation of Shiller’s CAPE: http://www.marketwatch.com/story/what-shiller-pe-ratio-says-about-markets-top-2013-03-18
Greedometer blog astutely notes the following.
“When stock market rallies get long in the tooth, the amount of leverage employed increases. Greed incarnate. This phenomenon is trackable via the amount of margin debt at broker dealers (this essentially represents the amount of money investors/speculators have borrowed “on margin” from brokers).
Margin debt reached new all-time highs in 2000, 2007, and…drumroll please…. again this year. The NYSE released the margin debt data for September a few hours ago. A new all-time high of $401B was seen.”
Any comments?
Thanks Martin
Yes, this is significant. It lines up with a few other big-picture indicators that suggest a bear-correction (20% +) is coming. As mentioned by other reader Brian–Shiller CAPE is 24 (top of its historic range), I have noted a potential expanding pattern for the S&P 500 in a recent blog, and Price/Sales, Price/Book, Price/Earnings readings are about in the middle to higher end of their longer termed ranges.
A cycle I follow suggests a pullback next year–I’ll present this chart on a blog soon. Meanwhile, there is, as mentioned before, time for one last drink at this party, then we really should hop in the cab and head home. In other words, indicators like margin debt and Shiller PE are big-picture indicators, and usually start to get frothy a while prior to an actual share price dump. I’m playing the trend ’til it ends- and my bet is that happens after Q1 2014.
The AUD/JPY among many other indicators has signaled that this last advance this week is possibly the end of the October parabolic rally in the S&P. AUD/JPY has tanked this past week while the S&P has made what looks to be one last push higher to suck in a few more longs before it retraces.
Agreed Dave–see my blog to be posted today (time for a correction)
Keith, I back tested the 10 year Shiller PE Ratio, and I could only find five times that it hit 24 or higher, and all ended badly. It happened in 1901. 1929, 1966, 1996 and 2007. Two of them, 1901 and 1966 came after if hit 24, and the other three came after it passed 27.5. While the markets can still go higher, the odds are really going against us.
And consider this. There has been only three times since 1950, that we had two consecutive double digit gains in the S & P 500, and that second year did not have at least one 7% plus decline, and those years were 1952, 1964 and 1989. We still have not had our 7% plus decline this year. What happened the following year? 1953 and 1990 were down years and we had a high single digit gain in 1965 before it all starting falling apart in 1966.
And consider this Keith. The U.S. economy appears to be heading back into a recession pretty soon. Why do I say this? I use four what I call leading economic indicators, and one is the Personal Savings Rate. My research shows that the average increase in the savings rate is 1.3% before a recession begins. The savings rate bottomed at 3.6% in January of this year, and it is now at 4.6%, and consensus is that Retail Sales is going to down a little for September, so if this is true, the September savings rate will probably be at 4.7% to 4.8%. We are getting very close to the 1.3% level. Our last two recessions started with a 1.1% and 1.2% increase. Each of the last eight recessions in America all came on the back of a large increase in the savings rate. There have been five false signals, but that last false signal was in 1986. Not good odds in my opinion.
And finally, speaking about cycles, I use a decimal cycle and my research shows that either in years 2 or 3 and 7 or 8, 10 out of 12 times since 1950, you got a 14% plus decline in the S & P 500. Sometimes these peaks started early and most of the damage occurred in these decimal years, like the 1980 and 2000 peaks, but since we did not have that 14% decline in year 2, and so far have not had it in year 3, we appear to be really overextended right now.
To me risk is very high, and while it is popular to believe that we got until the end of the best six months before we have to start worrying, I’m not sure we got anywhere near six more months to make our last profits.
Tony–this is an excellent comment. I agree–although as a trend follower, I feel its safe to be in until a change in trend breaks. I also note that seasonal for the TSX in particular have been shortening–TSX tends to peak in March lately, not May. This may be the case for the US markets this season.
Again, the signs are pointing towards an overbought market, with a likely top in the coming months. For that reason, I am less index-orientated during this seasonal period, and more individual stock picking. Further, I do have a finger on the sell trigger – should things change.
BTW–appreciate your notation on the Decennial pattern updated work you’ve done. It coincides with a 6-year cycle for the market to trough next year – indicating a peak in the coming months.
Keith, I am interested in your “sour view on commodities”.
I have been watching DBB, the Power Shares ETF (ETN?) for industrial metals. It is showing a triangle, is trading in a range but has not yet broken its downtrend.
Except for the US Fed’s activities, I would think the time is right for commodities to reverse since bonds seemed to have topped, mitigated by QE and stocks are overbought, leaving the third leg, commodities to start a period of outperformance. And since they have been down so long, their reversal, once it starts, could be substantial.
Hey Fred
I first wrote about my view on commodities in 2011 – which was good timing if I do say so myself –Here’s the blog: http://www.smartbounce.ca/?p=672
I also recently mentioned, with reasonable timing, that oil would roll over. Here’s the blog: http://www.smartbounce.ca/?p=2496 (hey–I also admit when I’m wrong, so let me gloat a bit here!).
Its not that all commodities look bad – although most look weak- but the broad basket may continue to follow that mega-cycle presented in my 2011 blog above–so I am more concerned about the more widely followed chunks of that basket (oil, metals). For example, copper broke out of its triangle to the downside. It looks to have another dollar down yet to go. Having said that—Here is a recent blog outlining a couple of bullish commodity charts: http://www.smartbounce.ca/?p=2370
Keith, one more thing. If you are a trend follower, as most technical analysis are, I would use weekly RSI as your sell signal. The first day it drops below 50, I would consider the primary trend down. I have back tested ten oscillators on the S & P 500 and the oil index and only 3, RSI, Slow or Full STO and ROC gave good results. So I then back tested these three over 13 indexes and I found that RSI gave the best results. It beat buy and hold by about a third. But you can get up to 8 signals in a year, when investors keep changing there minds. As you well know, there is no free lunch.
Tony–I created a little coagulation of indicators that I call the “Bearometer”–it combines specific levels on indicators, and assigns values for each of: Breadth (smoothed AD line) , Value (Shiller PE) , Momentum (weekly RSI), Trend (50 day SMA), Sentiment (a coagulation), and seasonality. I did manually backtest it for entry–it gives pretty good indications–its rated 1-8, where 1 is fully bearish, and 8 is back the truck up and buy stocks. Nothing, as you say, is a free lunch, so its only an indication of what might be coming, but it did pretty good in the backtest for the warnings on the tech bubble and Great Recession tops.. Watch the blog, I post its readings periodically. The last reading in September (2/8) suggested caution (http://www.smartbounce.ca/?p=2457). That brought us into a minor correction by October 10th. I will post its current levels shortly.
As said, though, nothing is the holy grail/ magic bullet/ whatever you want to call it. Welcome to the great unknowable stock market.