Fintech executive, writer, math geek, and investment systems developer. Founder and CEO of Altruist and Founder of FormulaFolios.

Long in the Tooth Stock Market Rally - Can it Keep Going up?

Long in the Tooth Stock Market Rally - Can it Keep Going up?

In a recent post I explored the historical outcomes of what has happened after the stock market hits a new all time hight (with at least one year since the previous all time high).  The results of the data were mostly good, which was somewhat reassuring. But...

For some reason this recent rally just doesn't seem right to me.  As much as I'd like the market to keep chugging along, and helping investors to grow their wealth, I can't help but wonder if there are some headwinds that could derail the rally.

As any self respecting market geek would do, I've been busy with some research.  To keep this blog post fairly simple, I've identified 2 areas worth sharing in this quick study:

  1. Market fundamentals

  2. Market trend

Fundamentals are the obvious reasons why stocks should go up.  Either prices are relatively low compared to earnings (a good buy), or prices are relatively high compared to earnings (not a good buy).

Market trends tend to be a little more opaque.  Sometimes the market goes up, just because it has been going up.  There may be no good reason for it, other than investors piling in because they don't want to miss out.

So lets take a look at some data in both regards.

Current Stock Market Fundamentals

There are numerous fundamental data points we could measure, but I want to keep this pretty simple, so I'll be focusing on earnings.  I'll also be focusing on the earnings of the S&P 500, just to be clear.

The most simple way to measure earnings relative to market price is via the Price to Earnings Ratio (or PE Ratio).  The math is as the name implies, just divide the price by the earnings.

There's a problem though with this measure, though, and it stems from highly unusual spikes and drops that only last a few months.  An example would be in Q4 of 2008, when the S&P 500 reported earnings of -$23.25 per share.  A solution to remove some of the short term sensitivity is to use legendary value investor, Benjamin Graham's, P/E10 (or Cyclically Adjusted Price to Earnings Ratio as he called it).

The premise is very simple, just take the inflation adjusted average earnings of the past 10 years, rather than only the past 1 year.  This creates a smoother trend of what direction earnings are moving, and allows us to see historically how good a "value" the market is right now.

Using this measurement we get a chart like this:

What you see is the stock market (adjusted for inflation per top line CPI) in grey, and the P/E10 (also adjusted for inflation) in blue.

The two are highly correlated, which means when one drops, so too does the other (same goes for rises).

The regression lines show where the market (or earnings) are relative to their mean.

Looking at regression alone, you can see the S&P 500 is currently 54% above the long term regression line; and P/E10 is 18% above the regression line.  Simply put, both prices and prices relative to earnings are quite a bit higher than normal.

Lastly, the small table shows the quintiles of P/E10.  For those that aren't familiar with "quintiles", this is every 20% band - i.e., the top 20% are the lowest P/E10's, the 21-40% (second quintile) are the second lowest, etc.

What I take away from this data is the following:

  1. The stock market is NOT a great value right now

  2. The stock market is overvalued (historically speaking) by about 20% at the moment

Since this chart was made, the P/E10 has risen to 23.51.  The average over the last 100+ years is 16.47 (mean).  Pretty much every great market rally has started with P/E10 below 15, most of them with P/E10 in single digits.

It's certainly possible for the market to continue going up, but this data supports the current rally being "long-in-the-tooth," so to speak.  In the past 100+ years P/E10's have only hit levels like they are today and continued to rally twice - the tail end of the roaring 20's - and the last couple years of the tech bubble 90's.

In order for market fundamentals to push the market higher, earnings need to grow at a pace faster than than stock market prices.  This would even out the P/E10.  However, earnings are actually lower than they were in 2007, and over the last 15 years has averaged less than 2% per year.  Expecting the market to rise at 10%+ annual clips with meager earnings growth is likely unsustainable.

To be clear, there is a lot more to market fundamentals than just P/E ratios.  What I have shared, though, clearly supports being at least a bit cautious in this current market rally.

Market Trends

A Market Trend is essentially just measuring the directional movements of the stock market based on price and volume.  It's rather simple, and is easy to see visually with charts.  Trends aren't sages, however, as nobody really knows when a pattern is just chance or truly meaningful.  It is interesting though to see where the market is today relative to past trends.

When looking at current market trends I tend to watch the S&P 500 in 3 different views:

  1. Long term trends (using monthly charts)

  2. Intermediate term trends (using weekly charts)

  3. Short term trends (using daily charts)

Here I'll show you each of these charts, and explain what they are saying at the moment.  Just watch the video below...

2013 Market Rally Conclusions...

Sadly, not much in investing is ever conclusive :(.  I do think however, that based on the above data, investors should start putting their guard up a bit.  Markets that are not fundamentally supported, nor technically supported (the trend), can still go up for months or years.  It is a sign though (historically) that a peak is forming, and once reached, a decline is on the way.

The best thing for the market at this time is to take a breather.  Perhaps a 5% drop, followed by a few months of sideways trending.  That would allow the shorter term overbought trend to dissipate  as well as allow for some earnings growth combined with lower stock prices to make the market look like a better value.

What do you think?

I'm curious how blog readers and clients feel abou this rally.  Do you think the market will continue to climb this year?  Do you think a correction is coming soon?  Please use the comment feature below to share your thoughts.  Maybe we can stir the pot some and get a good dialogue going on the collective wisdom of my many blog readers!

Regards,

Jason Wenk

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