The bounce in equities continued last week. The S&P500 added another 1.6% on dramatically lower volume, partly explained by the holiday-shortened week. Volatility, as measured by the VIX index, fell back into complacent territory, as hedges against further losses in equities were lifted. Breadth recovered slightly. The index of new highs minus new lows jumped up, and the percent of stocks above their 50 day moving average also rebounded.
Technically, the strong rebound in prices suggests that the bounce may have more room to run. And the daily charts on the S&P are supporting this view because they’re now turning bullish. The weekly charts, on the other hand, are still showing the weakness that began in June. A new high on the S&P500 would be required to reverse the weekly charts and build a bullish case.
In no way does any bullishness in the charts, however, change the fundamental problem that equity markets are not cheap and they’re still overly bullish. The Shiller P/E ratio is still at nose-bleed levels, levels associated with major turning points (down) over the past 100 years. And Investors’ Intelligence is still reporting that professionals are about 44% bullish and only about 20% bearish. As a reminder, over the past 100 years, as John Hussman has carefully pointed out, when markets are extremely over-valued and over-bullish, prospective returns have always disappointed, often leading to severe losses over the medium turn.
The US economy continues to limp along. ISM manufacturing is hovering just above the contraction line. Construction spending disappointed. Factory orders met expectations. International trade plunged; this will hurt the next quarter’s GDP report. ISM services, and remember that services account for 70% of the US economy, missed fairly badly. Initial jobless claims met expectations. And the big number of the week was the jobs report. On the surface, the news was good—195,000 new jobs were created, well more than the consensus forecast of 161,000. But on closer inspection, the news was not so rosy. The type of jobs created was lousy—all were part-time, not full-time ‘breadwinner’ jobs. Almost 400,000 part-time jobs were created in June, yet at the same time, over 200,000 full-time jobs were lost. Yet the establishment survey counts each new part-time job as a ‘new job’. The U-6 unemployment rate, which takes into account people working part-time for economic reasons, reflected this ugly development by soaring from 13.8% to 14.3% in one month. Also disappointing were the labor force participation rate and the employment to population ratio which both stagnated near multi-decade lows.
Finally, there’s a developing story on the earnings front. As stock prices rise back up to all-time highs, corporate earnings are fading away. The simple concept of ‘reversion to the mean’ suggests that earnings which have reached record levels relative to GDP and sales, were due to revert back down to more normal levels. The question was only when.
Well it seems as if this process has begun.
ThomsonReuters has recently reported that the ratio of firms giving negative to positive guidance has soared to about 7 to 1. Not only is this ratio much higher than it was during the meltdown of the Great Recession in 2009, but it’s at the highest level since 2001.
Therefore, in the face of collapsing earnings growth, the only way for the stock market to keep on rising is for it to be valued at an ever higher multiple.
It’s possible. But history shows that—eventually—equity values and multiples always catch up to corporate earnings.