The Market In Pictures – Mid-Year Update

July 24, 2014

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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

In November of 2013, I did a chart analysis of the markets at the time. Now that we have passed the halfway point in 2014 I thought it would be a timely retrospective to revisit that post and update those charts accordingly.

There is currently a debate being waged on Wall Street. On one side of the argument are individuals who believe that we have entered into the next “secular bull market” and that the markets have only just begun what is an expected multi-year advance from current levels. This would certainly be welcome news for anyone with money invested in the financial markets. However, the other side of the argument points to the ongoing effect of artificial stimulus and a suppressed interest rate environment that have only temporarily “masked” the underlying fundamental issues.

The series of charts below is designed to allow you to draw your own conclusions. I have only included commentary where necessary to clarify chart construction or analysis.

If you have any questions, or comments, you can email me or send me a tweet: @lanceroberts

Valuation Measures

The following chart shows Tobin’s “Q” ratio and Robert Shillers “Cyclically Adjusted P/E (CAPE)” ratio versus the S&P 500. James Tobin of Yale University, Nobel laureate in economics, hypothesized that the combined market value of all the companies on the stock market should be about equal to their replacement costs. The Q ratio is calculated as the market value of a company divided by the replacement value of the firm’s assets. Dr. Robert Shiller, also a Nobel Prize winning Yale professor, created CAPE to smooth earnings variations and volatility over time. CAPE is calculated by taking the S&P 500 and dividing it by the average of ten years worth of earnings. If the ratio is above the long-term average of around 16x, the stock market is considered expensive. Currently, the CAPE is at 24.42x, and the Q-ratio is at 1.00.

My friend Doug Short regularly publishes Ed Easterling’s valuation work. Ed Easterling, Crestmont Research, has done extensive studies on valuation and resulting long-term returns.

The next two charts are variants on Robert Shiller’s CAPE. The first is just a pure analysis of CAPE as compared to the S&P 500.

[For More On Shiller’s CAPE Debate read: “Is Shiller’s CAPE Really B.S.” and “Shiller’s CAPE, A Better Measure”]

The next chart shows the deviation of valuations from their long term average.

Measures Versus The Economy

One of Warren Buffet’s favorite valuation measures is Market Cap to GDP. I have modified this analysis utilizing real, inflation-adjusted, S&P 500 market capitalization as compared to real GDP. I have also noted the long-term median level as well as the average since 1990.

Since the stock market should be a reflection of the underlying economy, then the amount of leverage, or margin debt, in the market as a percentage of GDP could provide an important clue.

Deviation Measures

The following charts are measures of deviation from underlying trends or averages. The greater the deviation from the long-term trends or averages; the probability of a reversion back to, or beyond, those trends or averages increases. The first chart is the deviation of earnings from the underlying long-term growth trend of earnings.

The next chart is the deviation in price of both the S&P 500 and Wilshire 5000 from the 36-Month moving average. For more discussion on this chart read this.

The chart below is the same basic analysis but utilizing a 50-week moving average which is a more “real-time” variation.

The volatility index (VIX) is representative of investors “fear” of a correction in the market. Low levels represent investor complacency and no fear of a market correction.

Just For Good Measure

I recently wrote about the importance of “record market highs” stating:

“…while markets have risen over time, the markets spend roughly 95% of their time making up for previous losses.”

And A Reminder

Recently, John Hussman tweeted this chart of the S&P 500 that lists all of the warnings signs of a crash that we are experiencing now.

“Anatomy of a textbook pre-crash bubble. Don’t rely on further blowoff, but don’t be shocked. Risk dominates. Hold tight.”

This analysis can tell us much about where we are within the current market cycle if we choose to pay attention. While it is certainly easy to be swept up in the daily advances of the stock market casino, it is important to remember that eventually the “house always wins.” What has always separated successful professional gamblers from the “weekend sucker” is knowing when to step away from the table.