The S&P500 climbed higher by 3.7% on very low volume going into the holiday season. Volatility has also subsided tremendously; the VIX has dropped back down to levels that are almost back to those when the S&P was 100 points higher earlier this year. So, as the year winds down, a sense of calm or even complacency has spread over the equity markets. In a few short weeks, traders have decided there’s little to worry about.
In economic news, the data were again mixed for the US and negative for much of the rest of the world. At home, housing starts beat expectations, but virtually all of the beat came from apartment starts, not single family homes, which are still stuck at multi-decade lows. Meanwhile, existing home sales missed badly. Median home prices—down 3.5% yoy—continue to grind lower for the fourth consecutive year. The US housing market is still falling. It’s showing no signs of turning around. And just last week, the NAR admitted that it had overstated existing home sales every year since 2007 by over 14%, on average. So the housing crash, as bad as it was first looked, was actually even worse. The final revision to 3rd quarter GDP missed, coming in at 1.8%, worse than the 2.0% consensus estimate. Initial claims beat expectations, as did consumer sentiment. Durable goods orders, when stripped of airplanes and defense, were far worse than predicted; they fell 1.2% instead of rising 1.0%. Perhaps the worst numbers of the week were personal income and spending. Both missed badly, suggesting that consumers are fast running out of fuel (incomes) needed to boost the largest component of future economic growth (consumer spending).
Technically, the S&P is still in a multi-month downtrend. The peak for the year was reached at the end of April, and the S&P has been trending lower ever since. In fact, the S&P is now up for the year by LESS than 1%. The path taken to this almost UNCHANGED level has looked like a roller coaster ride, but at the end of the year, the stock market looks like it may end up very close to where it started.
On of the ways to judge whether the US stock markets are fairly valued is to compare them to where other major asset classes are trading, specifically asset classes that have a high positive correlation with stocks.
For example, of another correlated asset class has surged far ahead of the S&P, then traders could argue that stocks have more room to “catch up” with that asset class by rising further. In other words, the S&P could be argued to be undervalued.
So how does the S&P stack up against other major asset classes near the end of 2011?
Let’s start with Treasury yields, specifically the US 10-year. First, let’s point out that the S&P500 has been—especially over the last three years—positively correlated with 10 year Treasury yield. Also, it’s important to note that the Treasury market is a major (by size) asset class that competes with equities for capital.
The 10 year yield, as it turns out, is near historical lows. At the current 2.0% yield, the 10 year is implying that the S&P should be well under 1,000 and closer to 800. In other words, the 10 year Treasury is implying that the stock market is highly over valued.
Next, let’s look at the euro. The euro has also has a consistently positive correlation with the S&P. And over the last six months, the euro has been in a clear downtrend. At its current level, the euro is implying that the S&P should be well under 1,000 and closer to 900. The euro also says the S&P is overvalued.
International equity markets are also critical to compare to US stocks. The MSCI EAFE index is the benchmark for developed market stocks and is a great way to compare relative value with the S&P500. And the correlations are very high. Unfortunately, the EAFE index is down substantially for the year, wiping out, in fact, all of the gains from 2010, and then some. The EAFE index is implying that the S&P500 should be closer to 1,050. By this measure, the S&P is overvalued.
Now let’s look at industrial commodities—oil and copper. Both do have a strong positive correlation with the S&P. Yet in this case, both are roughly in sync with the S&P. Oil is implying the S&P is fairly valued; copper is implying the S&P is only slightly overvalued.
Finally, let’s look at high yield corporate bonds, which trade very much like equities due to their greater sensitivity to business cycles—like stocks, high yield prices rise a lot in good times, and fall a lot in bad times. Here, we find that high yield is actually prices above where stocks are priced. So high yield is implying that the S&P is slightly undervalued.
Putting it all together, we find that three markets, Treasuries, the euro, and EAFE, are pointing down for stocks. Commodities are saying stocks are fairly valued. And high yield corporate debt is saying stocks are slightly undervalued.
The final verdict? US stocks are slightly overvalued. And since these correlations are fairly strong, there’s a very good chance that this overvalued condition will correct itself in the first half of 2012.