What goes up must come down
I have attached some current thoughts on the current market environment. It is mostly a graphically representation of the markets with some value perspective and a look at long term reality.
20 year historical measures of the Shiller PE ratio and Tobins
Q Ratio demonstrate
that looking at the
market on a short term basis it may appear t
o be fairly valued or to some
undervalued.
W
h
ile
the
Tobins Q ratio is above its 20 year mean it is still within one standard
deviation
of its upper
bound
standard deviation. The PE ratio is approaching the range prior to the great recession. Conditions are
different currently than they were prior to the Great Recession but knowing this information lends
credence to caution.
While this may not appear alarming to some when looked at from a 30,000 foot
perspective the debt situation has changed but not significantly. Current margin debt is approaching
very high levels and has possibly replaced people using their homes as ATM
’
s
with mortgage refinancing.
Looking at the long
er
term history
all the way back
to 1952
the Shiller PE ratio and the Tobin
s
Q ratio
it
becomes very clear that valuations are stretched on equities.
Interesting to me is the fact that we are
approaching the levels preceding the great recession on the PE ratio and have surpassed the number on
Tobin
s
Q ratio.
Equity risk premiums are firmly above their mean when we look at 20 year history. This coincides with a
lower discount rate. When we look at the levels of the Equity Discount rate and co
mpare it to its high
we can clearly see the difference comes down to lower bond yields.
The VIX is almost at an all
-
time showing complacency in the equity markets.
I find this interesting given
the fact that we are seeing Equity Hedge funds closing due to what is perceived as high volat
ility. I think
they are closing due to poor market positioning and are have been underperforming the equity markets
persistently for the last 5
-
6 years.
Treasury yields have been going lower for the last 10 years and looking at this with respect to Equity
Risk
Premiums it appears investors are willing to take more risk in the equity markets. This will be further
demonstrated by looking at investor surveys.
The AAII Sentiment Survey shows that investors are less bearish than they have been in quite a while
. A
reading of 21.1 is well underneath the linear trend line as we can see from the chart above.
This
in my
opinion is a contra indicator of what investors should be doing.
Bullish Sentiment according to the survey shows that investors are more bullish than they have been
historically and is well above the line
a
r trend line.
We can clearly see that the long term trend line in the
survey is upward to t
he right which indicat
es increasing
bullishness on equities has persisted since 1987.
We also see that the allocation survey indicates that sentiment towards stocks has been improving and
is getting close
to the levels seen before the Great R
ecession.
In my opinion this is an indication that
more caution towards equities should be warranted.
Investor
allocation
towards bonds has been decreasing since 2010 but is still above its long term l
i
near
trend line
.
We can also see that investors have become less enamored with allocating their funds
toward bon
ds since 1987. This could be due to a number of factors but with the never ending
chorus of
analysts and media
espousing
their wisdom towards equities it is clear that
there is
a love affair with the
equity
markets in general.
The last chart here is from the Philadelphia Federal Reserve.
The Aruoba
-
Diebold
-
Scotti business
conditions index is designed to track real business conditi
ons at high frequency.
Its underlying
(seasonally adjusted) economic indicators (weekly initial jobless claims; monthly payroll employment,
industrial production, personal income less transfer payments, manufacturing and trade sales; and
quarterly real GDP
) blend high
-
and low
-
frequency information and stock and flow data.
The long term
trend is downward when we look at the data from 1997 to present.
Looking at the data on a bit of a
shorter te
rm scale shows that business conditions have slowly but surely improved but not a rate to
cause me to get enthusiastic about current conditions.
Given the valuation metrics that I demonstrated early in the writing and combining that with the
bullishness of the AAII Investor Survey I believe that increasing caution at this point is warranted. I do
think the markets in general are risky but given th
e fact of where we are currently in the cycle and
where we came from over the last five years I see the ma
rket as being a bit stretched currently.
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