US Equity Valuation

Last week, the S&P500 inched up 1.2%, but it still remained in the range (albeit at the upper end of that range) established almost three months ago. Volume was very light; in fact it was the lightest week, excluding vacation weeks, of the year. Again, this means there is very little conviction behind the buying of stocks. And volatility fell to near one-year lows. So there is simply no fear that stocks can correct in any meaningful way.

Technically, the US stock market is now even more overbought than it was last week, and the week before that.  The S&P is now hugging or even crossing above the upper Bollinger bands on both the weekly and daily charts. While momentum is weaker than it was at the beginning of the year, and small cap stocks are significantly off their recent highs, the S&P remains in an uptrend, with prices well above the 200 day moving average and with that average sloping upward.

In macro news, the releases were light and mixed. Initial jobless claims jumped higher than expected. The Chicago Fed National Activity Index plunged back into negative territory, down from a somewhat positive reading the prior month. Existing home sales disappointed, especially as home mortgage rates have climbed over the last 12 months. Also in housing, mortgage applications dropped. On the positive side, New home sales were slightly better than expected, as was the Kansas City Fed manufacturing survey.

So now, almost halfway through 2014, how does the valuation of the S&P500 look from a historical perspective?

We all know that prices are hovering near all-time highs, but are these prices fair—when compared with historical markers—especially as so many pundits on financial news outlets keep asserting that US stock prices are not overly high…..and therefore not at risk of any serious correction.

John Hussman, of the Hussman Funds, does a great job highlighting some of these measures. And they’re not pretty. Recently, he states:

Valuation measures remain extreme, with the market capitalization of nonfinancial stocks pushing 130% of GDP (relative to a pre-bubble norm of about 55%)

Keep in mind, this is a favorite measure of none other than Warren Buffett.  Hussman also uses this:

the S&P 500 price/revenue ratio at 1.7, versus a pre-bubble norm of 0.8

And if one were to apply these measures to actual investment decisions, the implication would be that one should consider lightening up on equities and certainly NOT putting new money to work at these prices.

Note that for valuations simply to return to historical norms, using the measures above, prices would have to fall by MORE than 50%.

What Hussman didn’t mention is that prices tend to fall much more quickly than they tend to rise. This means that many years of advances in the S&P could be wiped out in a matter of months, when the S&P finally corrects. Recently, these types of fast losses happened after the tech bubble imploded in 2000 and the housing bubble blew up in 2007.

So if you do decide to stay all-in and put new money to work into stocks, you must either disregard all of the above, OR you must conclude that history will never repeat itself.

As Hussman so eloquently puts it—good luck with that.

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