Dancing Near the Exits

The party doesn’t seem to want to end.  And until the Fed takes away the punchbowl, it really shouldn’t end.  On extremely low volume, the S&P500 jumped 4.5%. 

There was very little economic news, and most of it was weak.  The ISM non-manufacturing index came in slightly less than expected at 50.9.  Consumer credit fell by $12 billion, even though the Cash for Clunkers program added billions of dollars of consumer installment debt.  Initial jobless claims were 521,000, which was slightly better than forecast but still solidly in the dismal 500,000 range. 

The technicals still point to a topping formation on the daily charts.  The uptrend in the weekly charts continues, although it is suggesting a topping pattern as well.  The long-term monthly downtrend that began in the fall of 2007 is still in effect.

After touching on the various reasons why the equity markets are levitating, it would be useful to examine the actual valuations today relative to valuations in prior periods.   Are today’s valuations cheap, fair or expensive?

David Rosenberg, who spent 20 years at Merrill Lynch, tried to answer this question in a paper he published last week.

Using trailing operating earnings, the S&P500 now trades at a 28x multiple, up 10 points from the March lows.  But according to David, the economy begins expanding (as it probably did in Q309), it typically trades at a 15x multiple.  So today’s P/E is almost 100% higher than in past economic turning points.

Also, David points out that the trailing as-reported P/E is almost 140x, which is three times higher than the P/E at the peak of the tech bubble. 

He states that “going back 60 years, there have been only 14 months when the trailing multiple was as high as it is today, and that covers 10 recessions.  This implies that the market is in the top 2% expensive terrain historically, and those other times basically covered the tech mania of a decade ago.”

David goes on to review the dividend yield, the forward earnings multiple, and the price-to-book ratio.  On all counts, the S&P500 is extremely overvalued relative to other historical periods.

He concludes with the reminder that 60 years of historical data suggest that “the market typically faces serious valuation constraints once it breaches the 25x P/E multiple threshold.  The average total return a year out for the S&P500 is -0.3% and the median is -6.2%.”

So as many traders and investors continue to dance at the party thrown by the Fed, the wisest ones are keeping an eye on the exits.  They’re convinced that when the music stops, they’ll be the first ones to dash out the door, making a clean escape from the carnage left behind. 

Unless, of course, they all get trampled before reaching the door.

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