Sentiment figures from the American Association of Individual Investors, The National Association of Active Investment Managers and the Investment Company Institute’s mutual fund cash levels are all flashing bullish numbers at or above the 2007 highs.
If you have watched or read any of the financial media in the past month, you have seen analyst after analyst and strategist after strategist proclaim the bear market is dead and the bull market has nowhere to go but up. (IE: Bloomberg survey showed 13 out of 13 strategists were bullish, USA Today had 5 out of 5 bullish and Barron’s famed Round Table had 10 out of 10 bullish participants.)
Unfortunately, the hard data doesn’t support the bullish thesis.
- S&P 500 P/E Ratio is over 16x, while Shiller’s CAPE is over 23x The 5 year average P/E Ratio is over 33x
- Bullish per cent Index for the S&P 500 is over 86% (80% is a sell signal)
- 90% of stocks are above their 200 day moving average, 2007 peaked at 91%, then the market collapsed.
- Case Shiller index shows the housing market is giving indications of a double dip in process
- 30 Year Treasury interest rates are up 33% off their low, driving the bond price down almost 13%
- According to recent Fed minutes, they believe more stimulus is needed
- Congress was elected with a mandate of austerity, not growth.
- Federal Debt to GDP still in the 100% territory according to Fed data
- Total Debt to GDP still just under 400%, according to Fed data
We are concerned that investor’s collective memories have deleted the 2007/2008 decline. Investors seem to act like it never happened. Bullishness is advancing and bearishness is almost non-existent, while money is pouring into equity mutual funds and the stock market.
They can’t be setting themselves up for a fall again, can they?
Markets are Overbought
The Bullish per cent Index (BPI) measures the percentage of stocks that are in bullish Point & Figure chart patterns. The highest the index can measure is 100%. The lowest is zero per cent. A disciplined approach will start to sell stocks once the index hits 80%. Once 80% of all stocks are in bullish patterns, there isn’t much upside left, so the only direction left is for a reversal, for stocks to start heading lower.
Today, the index is at 86%, which is higher than the peak in 2007. It is not necessary that stocks have to decline immediately, or that the BPI can’t go higher.
The number of stocks above their 200 day Moving Average (MA) stands at 90%. Like the BPI, this index measures the momentum of stocks and the sentiment of investors. A high percentage of stocks over their 200 day MA shows a high degree of bullishness among investors. This is a contrary indicator because once a high percentage of stocks are above their MA, the next move is down.
Fear has been replaced by Complacency
The VIX Index measures volatility. The CBOE defines it this way: The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.
In other words, the lower the index, the higher investor complacency. The higher it goes, the higher the fear level. Today’s measurement of the VIX shows complacency is near the 2008 lows. This is a bad sign for investors in the short term.
As you can see, the index itself can be very volatile. Fear can spike almost without warning. (Except for the high complacency reading.)
Bear not Correction
These indicators can be quickly resolved by a fast reversal of the markets and a drop of 10% to 15% over several days or weeks. The BPI would drop 30% or more and the number of stocks above their 200 day MA would surely decline significantly. The VIX would probably show an increase in fear as the index jumped 50% to 100% or more.
Investor sentiment might cool a bit and even mutual fund cash might tick up a little, giving perma-bulls all the more reason to dive into stocks.
But the damage done to the economy and to the markets won’t be resolved by the Fed waving its magic wand of monetization. Fiscal engineering does not replace sustainable economic activity and sound fundamentals. Investors have been behaving as if the economy is on solid ground and the market decline of 2007/08 was just a glitch in the ever upward march of share prices.
The P/E Ratio
Unfortunately, earnings can be manipulated. Companies can pile on the losses in a year that is expected to be bad anyway and crush their earnings while squirrelling away profits to be brought out when an earnings surprise might be needed to boost the share price. It is because of this that the P/E Ratio can have wide swings from year to year.
To counter this phenomenon, Robert Shiller from Yale has developed the CAPE or Cyclically Adjusted P/E. Today, the Shiller CAPE is about 23x earnings, well above historic fair value of between 13 to 15 times earnings.
At Cornerstone, we noticed that there seemed to be a cycle within the P/E multiples. We averaged the trailing 12 month P/E over a 5 year period to take out any of the wide swings and noticed a clear cycle that was about 25 to 30 years in duration.
The chart above shows that the bubble drove the ratio up to 32.49, well above any previous peak. The correction in 2007/08 brought it down to only 20.34, still higher than previous peaks. To show a true bottom in the cycle, the 5 year average needed to decline to the single digits, somewhere around 8 – 9. Worse, the ratio has skyrocketed back up again, higher than the bubble high.
Investors are hoping that earnings will save the day and bring the P/E Ratio down. The coloured lines at the end show 3 different scenarios based on S&P’s earnings estimates for the next 2 years. It shows that even with S&P’s optimistic earnings projections, the ratio barely moves lower. As long as the ratio is this high, investors are at risk.
To bring the ratio down to normal levels, earnings will have to grow at rates never seen before, with annual increases of 100% or more, or the market has to decline about 50% and stay there for a period of months, maybe years.
This would be a real bear market, not just a correction.
First, the market has to breakdown
This sounds rather intuitive, to go down, first you have to stop going up, but there is a disconnect between price and value.
A Mercedes is an expensive car, based on its price. But without an engine, what kind of value does it have, especially at the same price? And then take away the transmission and wheels. Does it have the same value then? Or does the price have to come down to reflect the lower value?
The economy has been driven by economic stimulus from the Fed for the past 2 years. The fact that the Fed had to start QE2 (another round of pumping liquidity into the system) shows that the activity has not been sustainable, there is no engine in the car. Looking at the P/E multiples and the unsustainable nature of the economic growth, is the price of the market justified? Or have investors driven up the price of the shares, regardless of the value of the shares?
More importantly, are the Fed’s strategies to spur the economy on going to end up being a drag on it in the future (mountains of new debt, debased currency and higher inflation)?
Short Term Charts
Chart 1 on page 4 shows a rising pennant pattern from the summertime lows. A breakout above the current level could be indicative of more upside, maybe another 10%. (Chart 2) A break below could send the market down 7% quickly. A drop to the 2010 summertime lows would be a 20% decline. These declines would be necessary to shake out some of the excessive bullishness built into the market right now.
Long Term Chart
Longer term, investors should familiarise themselves with the reality of the long term trend into which they are investing. Chart 3 shows the S&P 500 since the great bull market began in 1982. The chart shows it had a normal bull market trend line up until 1995, at which point the chart took a sharp turn north.
First was the Tech Bubble, which ended badly in 2000. Then came the Real Estate Bubble, which started to collapse in 2007 and really picked up steam in 2008. Now it looks like a new bubble is brewing. Like the previous bubbles, it is not based on fundamentals but on liquidity and a flood of money. This time the Fed is printing Dollars, monetizing the debt to avoid a Greek-like fiscal crisis.
Interestingly, the bottom of the 07/08 bear (actual bottom in 03/09) touched the bull market trend line that extends all the way back to 1982. One of the characteristics of this type of trendline is that the lows can be connected in a straight line. The lows in 1982, 1984, 1985, 1987 and 1990 all line up with the 2009 low. Extending it forward could give an indication of the next low. At this point, it appears to be about 37% below the current level.
This could be the low end of the trading range we expect. That could give a real buying opportunity. Yes, I said it, a buying opportunity. But not just any stocks. Our initial focus would be on high dividend paying stocks. We want to get income into the portfolio while we wait for the market to work itself out and as we mentioned before, that could take years.
Highest Risks Not in Stocks
Here’s the surprise for Cornerstone Commentary readers, we don’t believe the stock market is the biggest risk facing investors for 2011. Our research indicates that the bond market may carry the greatest risks both short term and long term. More on those risks in another report.
At best, we expect to see the stock market trade sideways in a wide trading range for the next several years – maybe Dow 8,000 to 12,000 or 9,000 to 11,500, or any variation of that. In the short term, the stock market seems to be hitting a ceiling and running out of steam.
While the stock market could have a substantial decline and soon, we believe the greatest real risks to investors are in Washington, the bond market and the Dollar.
Bill Gross from PIMCO summed up his 2011 outlook this way: “Above all, remember that all investors should fear the consequences of mindless U.S. deficit spending as far as the… eye can see. Higher inflation, a weaker dollar and the eventual loss of America’s AAA sovereign credit rating are the primary consequences. “
The Bubble is Back and Everyone’s a Bull – PDF
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