Concerns regarding a double-dip recession moved to centre stage over the past few weeks and spooked stock markets. Yes, the global manufacturing PMIs look awful (see Global PMI Roundup (July 2011) – Manufacturing tanks), investor confidence has been shattered by the ongoing uncertainty in the Eurozone, the currency war has broken out again with Switzerland and Japan trying to lower the value of their currencies, and rumours are flying about French banks being in trouble.
The significant stock market pullbacks with major support lines broken have prompted me to ask how far the market still has to fall. Or put in another way, are global equities and especially the U.S. market offering value after the shake-up?
I have updated Robert Shiller’s cyclically adjusted price earnings ratio, or PE10, for the S&P 500, Index which takes into account the average earnings over 10 years instead of the normal PE based on the past year’s trailing earnings. The S&P 500’s close of 1 178 on Friday took the PE10 to 19.6 compared to a month-end high of 23.9 in May.
The current PE10 is lower than the PE10 of 20.0 in July last year and the cheapest valuation since September 2009. But compared to the long-term average of 16.7 the market is still overpriced by 15%. So what do I make of it?
In previous blogs I pointed to the influence of consumer sentiment on the PE10. In the graph below it is evident that the PE10 of the S&P 500 in May was priced as if the Conference Board’s Consumer Sentiment Index was in excess of 70 while it was already lower at 61.7.
Currently the PE10 is roughly in line with the latest reading of 59.5 for the Consumer Sentiment Index. So what happened? The stock market corrected from being expensive to fair value compared to the underlying consumer sentiment – the most important indicator of the U.S. economy.
You may argue that the market is still overpriced by around 15% compared to history. If the relationship between consumer sentiment and the PE10 holds true, a further drop of 15% in market value will point to the Consumer Sentiment Index falling to approximately 45 from the current 59.5. The million dollar questions are therefore: “Where is consumer confidence heading?” and “Is the market going to overshoot on the downside?”
But let me look at the more traditional measure – the price to earnings ratio based on 12-month trailing earnings.
The current PE multiple of 13.8 S&P 500 makes U.S. stocks the cheapest since July 1989!
I am of the opinion that we have been witnessing a very healthy and necessary correction from a frothy overvalued market. However, given the oversold condition of the market and the fact that we the S&P 500 showed two consecutive 90% up-days last week, I expect the down-cycle might have bottomed or is close to doing so. I also expect China’s manufacturing sector to display its normal seasonal strength from August onwards, while Japan’s recovery from the twin disasters is already evident in machinery orders and exports.
As mentioned elsewhere on the blog, it is not yet possible to know whether the fat lady of the 30-month bull market has made her appearance. The nature of the expected rally, especially to what extent up-days are supported by solid volume, would, among others, provide a clue as to whether the cyclical bull is still alive and kicking.