What Are Valuations Telling Us?
(October 11, 2009)
First Note: As we've discussed many times in our discussion forum, the successor to Vista (the failed operating system), Microsoft's Windows 7 will be released on October 22nd. All reviews so far suggest this is a must-have for those running Windows XP or Vista. I plan on getting a new laptop on the midnight of October 22nd (with a pre-installed version of 64-bit Windows 7, of course). And if that isn't enough, recent leaks suggest that Microsoft is already working on a 128-bit version of Windows 8 and 9! With corporate IT budgets slashed to the bone, I expect Windows 7 to jump-start the next technological upgrade cycle in many major US corporations.
Second Note: If this reflects the level of investment sophistication at the Abu Dhabi Investment Council, then I do not want to work there.
Dear Subscribers and Readers,
Let us begin our commentary by reviewing our 9 most recent signals in our DJIA Timing System:
1st signal entered: 50% short position on October 4, 2007 at 13,956;
2nd signal entered: 50% short position COVERED on January 9, 2008 at 12,630, giving us a gain of 1,326 points.
3rd signal entered: 50% long position on January 9, 2008 at 12,630;
4th signal entered: Additional 50% long position on January 22, 2008 at 11,715;
5th signal entered: 100% long position SOLD on May 22, 2008 at 12,640, giving us gains of 925 and 10 points, respectively;
6th signal entered: 50% long position on June 12, 2008 at 12,172, giving us a loss of 2,307.06 points as of Friday at the close.
7th signal entered: Additional 50% long position on June 25, 2008 at 11,863, giving us a loss of 1,998.06 points as of Friday at the close.
8th signal entered: Additional 25% long position on February 24, 2009 at 7,250;
9th signal entered: 25% long position SOLD on June 8, 2009 at 8,667, giving us a gain of 1,417 points.
In our last few weekend commentaries, we stated that while the market was overbought – and while it was subject to a couple of significant systematic vulnerabilities (namely, the shakiness of both the European banking system and US commercial real estate) – we would remain 100% long in our DJIA Timing System. While retail investors continue to redeem their US equity mutual funds (domestic equity mutual funds suffered a $3.8 billion outflow for the week ending September 30th), we recognize that the intermediate trend of the stock market remains up – and that, given the strong upside breadth and volume since early March 2009 – it would be notoriously difficult to time any corrections in the stock market, if there are any.
Our stance remains the same. While the stock market remains overbought (and while the Dow Transports did not confirm the Dow Industrials on the upside, as we would cover later in this commentary), the lack of any flagrant non-confirmation by our other technical indicators and the lack of any extreme overvaluations in the stock market suggests that a 100% long position in our DJIA Timing System remains prudent. But there is always a time for everything. Should the stock market get more overbought on relatively weak breadth and/or volume (we will let you know as soon as we change our stance on the market), we would not hesitate to shift to a more defensive (most likely 50% long) position in our DJIA Timing System. Let us now discuss the gist of this commentary.
So what are stock market valuations today now telling us? Simply: “Not much.” The following chart, courtesy of Ned Davis Research, shows the price-to-book ratio of the S&P 500 from 1978 to the present. As shown, the P/B ratio of the S&P 500 is currently at around 2.2, which is just below its 32-year average of 2.4:
On one camp, the analysts advocating the “New Normal” scenario (e.g. PIMCO) as the future direction of the US economy believe that a 2.2 P/B ratio is too high, given a deleveraging US economy which would inevitably lead to a US GDP growth rate of only 2% (or below) for the foreseeable future. Meanwhile, the analysts in another camp suggest “business as normal.” They argue that the historical growth rate for US GDP – based on population and productivity growth – should recover to its 3% “norm” once the current recession is over. In such a scenario, a 2.2 P/B ratio may actually be on the low side, especially given the record monetary and fiscal stimulus packages that global governments and central banks have implemented around the world (as well as the emergence of various sovereign lifelines as implemented by the Federal Reserve, the IMF, and a new Asia-based “bailout” fund). In other words, not only is the “Bernanke Put” alive and well, even other institutions such as the European Central Bank, the IMF, and the Chinese government have joined in the act. Combined with record low interest rates, the bulls would argue that a 2.2 P/B ratio on the S&P 500 is still too low.
The bears, on the other hand, would not only cite the inevitability of the “New Normal” scenario, but also the lack of political will (in light of the populist sentiment against further bank bailouts) to implement the policies that Bernanke and Congress implemented over the last two years. Some bears have even argued the permanent impairment of the US capitalist/innovative spirit (which I highly take issue with). In such a scenario, not only would future US stock market returns be mediocre, but the value of the US Dollar Index would also experience a permanent decline.
Another valuation factor that I regularly track – Morningstar's aggregate valuation of its entire coverage universe of over 2,000 stocks (covered by the competent analysts at Morningstar) – is now 2% overvalued, as suggested by its current ratio of 1.02 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). As shown in the following chart, courtesy of Morningstar, this ratio sank to as low as 0.55 on November 20, 2008 (this represented its all-time low since the inception of this indicator in mid 2001), and as high as 1.14 on December 31, 2004:
Both the S&P 500's P/B ratio and Morningstar's proprietary valuation indicator suggests that the stock market is currently, more or less, trading at “fair value.” Subscribers should note that – given what happened to corporate earnings over the last year – Morningstar's underlying growth assumptions in their discounted cash flow analyses are still relatively conservative. As the weighted cost of capital continues to decline, and as global economic growth recovers, there's a good chance Morningstar's earnings growth assumptions for its coverage universe would be revised to the upside. In other words, Morningstar's valuation ratio of 1.02 for its entire coverage universe may be conservative. Given the strong upside breadth and volume in the global equity markets since early March 2009, and given that many retail investors are still cautious, probability suggests that the intermediate trend of the US stock market remains to the upside.
So Henry, when will MarketThoughts shift to a more defensive position (i.e. completely neutral, or more likely, 50% long) in your DJIA Timing System?
In the short-run, we may turn defensive in our DJIA Timing System should the market continue its rally (up to DJIA 10,500 or higher) on relatively weak breadth AND volume. Even in this case, we will only be looking for a correction – not the beginning of a major bear market. For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many other things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital). In the short-run, however, we may turn more defensive should breadth and volume do not confirm the Dow Industrials on the upside. One breadth indicator that we track on a daily basis is the NYSE Common Stock Only Advance/Decline line. As mentioned on our website, the A/D line has been and remains one of the most popular tools in measuring the breadth of the broad market. It is a cumulative sum of the daily differences between the number of stocks advancing and the number of stocks declining. Plotting this indicator on an intermediate term or long-term basis is a great way to gauge the strength (and liquidity) of the broad market. Traders believe that cap-weighted indices such as the NASDAQ Composite or the S&P 500 cannot have a sustained advance if they rise without the A/D line confirming (commonly called a “divergence”). There have been various times in history when the A/D line has acted as a precursor of a significant stock market top – the most recent being a topping out of the NYSE A/D line in July 2007 – three months before the peak of the October 2002 to October 2007 bull market in the Dow Industrials, and prior to that, the topping out of the NYSE A/D line in April 1998 – nearly a whole two years before a corresponding top in the major indices such as the DJIA, the NASDAQ Composite, and the S&P 500. The following three-year chart showing the NYSE CSO A/D line vs. the NYSE Composite Index (courtesy of Decisionpoint.com) suggests that this rally isn't over yet, as the NYSE CSO A/D line has continued to confirm both the NYSE Composite and the Dow Industrials on the upside since the early March 2009 bottom:
Let us now discuss the most recent action in the U.S. stock market via the Dow Theory. Following is the most recent action of the Dow Industrials vs. the Dow Transports, as shown by the following chart from January 2007 to the present:
For the week ending October 9, 2009, the Dow Industrials rose a whopping 377.27 points while the Dow Transports rose 182.99 points. While the Dow Industrials made a new rally high last week, the Dow Transports is still 3.5% below its mi September highs. With the Dow Transports failing to confirm the Dow Industrials on the upside, and with the stock market still overbought and vulnerable to weakness in the European banking system and US commercial real estate market (at the very least, these two sectors still need to raise a substantial portion of capital from the equity markets), I continue to expect the US stock market to be mired in a consolidation phase for the rest of this year. Should the Federal Reserve withhold liquidity creation to try to prop up the US Dollar Index, then I expect the market to correct over the next few weeks. For now, given that the intermediate trend remains up, we will maintain our 100% long position in our DJIA Timing System.
I will now continue our commentary with a quick discussion of our popular sentiment indicators – those being the bulls-bears percentages of the American Association of Individual Investors (AAII), the Investors Intelligence, and the Market Vane's Bullish Consensus Surveys. The latest four-week moving average of these sentiment indicators increased from a reading of 8.2% to 8.6% for the week ending October 9, 2009. Following is a weekly chart showing the four-week moving average of the Market Vane, AAII, and the Investors Intelligence Survey Bulls-Bears% Differentials from January 1997 to the present week:
While the four-week moving average is still far from a historic overbought level, its “spike” from early March to the present suggests that individual investors have gotten too bullish, too quickly. That is, while there is still enough “fuel” for a longer-term rally, probability suggests that the stock market will need at least consolidate further before we can embark on a further rally. Moreover, while the “Bernanke Put” is still alive, the Federal Reserve has already indicated it will end its “credit easing” policy at the end of 1Q 2010 – thus constraining liquidity creation and support for the financial markets. For now, we will remain 100% long in our DJIA Timing System, but as we mentioned, we would not hesitate shifting to a more defensive position should the Dow Industrials rallies to above the 10,500 level on relatively weak breadth and volume.
I will now close out our commentary by discussing the latest readings of the ISE Sentiment Index. For newer subscribers, I want to again provide an explanation of ISE Sentiment Index and why it has turned out to be (and should continue to be) a useful sentiment indicator going forward. Quoting the International Securities Exchange website: The ISE Sentiment Index (ISEE) is designed to show how investors view stock prices. The ISEE only measures opening long customer transactions on ISE. Transactions made by market makers and firms are not included in ISEE because they are not considered representative of market sentiment due to the often specialized nature of those transactions. Customer transactions, meanwhile, are often thought to best represent market sentiment because customers, which include individual investors, often buy call and put options to express their sentiment toward a particular stock.
When the daily reading is above 100, it means that more customers have been buying call options than put options, while a reading below 100 means more customers have been buying puts than calls. As noted in the above paragraph, the ISEE only measures transactions initiated by retail investors – and not transactions initiated by market makers or firms. This makes the indicator a perfect contrarian indicator for the stock market. Since the inception of this index during early 2002, its track record has been one of the best relative to that of other sentiment indicators. Following is the 20-day and 50-day moving average of the ISE Sentiment Index vs. the daily S&P 500 from May 1, 2002 to the present:
For the week ending October 9th, the 20 DMA increased from 122.1 to 127.1, while the 50 DMA increased slightly from 122.9 to 123.7. Note that both the 20 DMA and the 50 DMA are now in an uptrend. With the 20 DMA also now above the 50 DMA, probability suggests that sentiment will get more bullish as we head into Thanksgiving – suggesting that the stock market rally has further to go. That said, with many of our technical and sentiment indicators still in overbought conditions, my sense is that the market will continue to be mired in a long period of consolidation over the next few months, especially given the liquidity troubles in the European banking system and US commercial real estate market. For now, we will remain 100% long in our DJIA Timing System.
Conclusion: At this point – with the S&P 500 trading at a P/B ratio of 2.2, and with other valuation metrics (such as Morningstar's proprietary valuation indicator based on its universe coverage of over 2,000 stocks) at near “fair value” levels – stock valuations are simply not “telling us much.” While the compelling valuations in early March 2009 are long gone (it makes more sense to buy blue chip/defensive names at this point), we remain bullish on the intermediate uptrend given the strong upside breadth and volume we've witnessed in the stock market since early March. In the short-run, we may turn defensive in our DJIA Timing System should the market continue its rally (up to DJIA 10,500 or higher) on relatively weak breadth AND volume. One indicator that may provide such a sell signal is the NYSE Common Stock Only A/D line – however, at this point, this indicator is still giving us the “all clear.” Even should this scenario pan out, we will only be looking for a correction scenario – not the beginning of a major bear market. For us to turn very bearish on the market again (i.e. for us to enter into a short position in our DJIA Timing System just like we did in October 2007), many other things would need to line up, including a potential fiscal policy mistake (i.e. higher taxes), economic policy mistake (i.e. major protectionist threats), or a monetary policy mistake (such as the failure of the ECB to assist the Euro Zone's banking system in raising capital).
While we no longer believe European banks pose a global systemic risk, there is no denying that European banks will need to raise a substantial amount of capital in order to resume its “normal state” of lending going forward. As a result – while this is relatively bullish for the global economy (since this would jump start lending again) – this would be very dilutive for current equity holders – and thus I look for both European and US bank shares to underperform over the next 12 months. In addition, the ongoing decline in US commercial real estate prices continues to pose a global systemic risk, and is something that we will continue to track for the foreseeable future. For now, our short-term belief is that the US stock market will be mired in a consolidation phase for the rest of this year. Subscribers please stay tuned.
Henry To, CFA