Stock Market Valuation–A Long-Term View

The low volume push higher continued last week.  The S&P500 finished higher just under 1%.  Once again, the VIX (or fear) index did not confirm the price rise; the VIX finished the week virtually unchanged. 

The technicals are still pointing to dangerously overbought levels on the weekly charts.  When almost 70% of the stock trading is done by computers trading with each other, one has to wonder how much longer the melt-up can continue, especially without broad retail participation.  The daily charts have already started breaking down.  A clean top-formation has emerged and next week will determine if this breakdown is valid.

The economic data mostly weak.  Personal income was lower than forecast; personal spending came in as expected.  The bad news here is that reasonably strong recoveries normally propel incomes higher; instead, incomes are showing no signs of growth.  And without personal income growth, the economy will have a hard time expanding.  The Case-Shiller index showed a drop in home prices, raising well founded concerns that home prices could resume their steep declines.  Chicago PMI was lower than expected.  Factory orders were stronger.  Initial jobless claims came in as expected, but still well above the 400,000 threshold associated with job growth.  Nonfarm payrolls, at 162,000, were lower than the 200,000 expected.  And when temporary census hires, the birth/death adjustment and weather factors are removed, the month of March lost jobs.  Although the headline unemployment rate stayed at 9.7%, the broader under-employment rate (U-6) rose to 16.9%.  And confirming the weak results with personal incomes, the average weekly earnings fell 0.1% (they were expected to rise 0.2%).

Societe Generale recently analyzed the long-term price-to-earnings ratio using Robert Shiller’s adjusted earnings (he smooths earnings over ten years to smooth out volatile fluctuations).  The analysis focused on separating PE levels into five historical levels–the 1st being the most expensive, and the 5th being the least expensive (see the chart below).

The point, obviously, is that you’d prefer to be a buyer in the 4th or 5th categories, and you’d prefer to be a seller in the 1st or 2nd.

A couple of important observations.

First, the stock market fell into the cheapest quintile in eight separate decades  out of the 12 decades analyzed since 1881.  So a patient investor had many opportunities over a lifetime to buy stocks cheaply. 

Second, many of these cheap periods spanned months or even years.  In other words, an investor didn’t have to be glued to the daily ticks of the stock market to avoid missing the opportunity to buy cheaply; he or she could do so at almost a leisurely pace over dozens or hundreds of trading days.

So how did the lows of March 2009 compare?

As horrific as our financial crisis was (and still may be), the S&P500 NEVER reached the cheapest quintile.  And the S&P entered the 4th cheapest quintile, but only for about a week!

The conclusions are simple.  First, stocks today are in the most expensive quintile; this is not a safe time to buy and hold.  Second, unless history fails to repeat itself, unless this time is really different, then PE’s will sooner or later fall into the cheapest 5th quintile.  And finally, when they do, we will have plenty of time to buy stocks at these cheap levels.

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