Valuation, Liquidity and Leverage Updates
(April 22, 2011)
Dear Subscribers and Readers,
Note that Rick Konrad, our guest commentator, will be penning this weekend's commentary instead. The topic is still up in the air, but I believe he may mention his recent stock pick, Supervalu (SVU). The stock has appreciated nearly 50% since Rick first discussed it in his January 7 commentary.
Moving on—as the major market indices continue to power to new highs, and as earnings season heats up—it is now time to update our subscribers of our 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 slightly overvalued, as suggested by its current ratio of 1.04 (a value of 1.00 is assigned to a particular stock if it hits Morningstar's definition of “fair value”). Note that this ratio was also at 1.04 since our last update on April 3. 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. Moreover, as shown in the following chart, courtesy of Morningstar, this ratio is still about 6% below where it was right before the market had its last major correction starting late April 2010:
Morningstar's proprietary valuation indicator suggests that the stock market is slightly overvalued. More important, subscribers should note that – given the trend of corporate earnings over the last two years – Morningstar's underlying growth assumptions in their discounted cash flow analyses have gotten more aggressive since the March 2009 bottom. In addition, the weighted cost of capital has declined dramatically – suggesting that valuations may be stretched, especially given the recent rise in inflationary expectations and the still-unresolved European sovereign debt crisis. In other words, Morningstar's proprietary valuation indicator provides further evidence that the market is now highly vulnerable to a correction. However, there is still some upside to go in the short-run—I would not be surprised if the market rallies another 3% to 6% before experiencing a major correction. Should the Dow Industrials rally to the 12,750 to 13,250 level, we will likely go 50% short in our DJIA Timing System.
Let's now shift to a discussion on U.S. market liquidity. One measure is the amount of cash sitting on the sidelines, as measured by the ratio of the amount of money market funds plus checkable deposits divided by the S&P 500's market cap; see our July 26, 2009 commentary for more background. Since its February 2009 peak, it has declined very quickly. As of the close yesterday, it declined to another cyclical bull market low, as shown in the following chart:
Note that we have updated the numbers as of Thursday evening. As referenced in the above chart, the ratio of investable cash (retail money market funds + institutional money market funds + total checkable deposits outstanding) to the S&P 500 market capitalization has been consistently declining since February 2009. The ratio temporarily bottomed at the end of April, with the ratio rising by 3.99% from the end of April to the end of August (from 32.57% to 36.56%). However, with the stock market rally since the beginning of this year, this ratio declined to a cyclical bull market low of 28.39% as of yesterday at the close (its lowest level since the end of December 2007). More important, it has declined too far, too fast, and is very low compared to its readings over the last three years. The low reading in this liquidity indicator suggests that the market's upside is limited for the foreseeable future and that it is highly vulnerable to a sizable correction.
I now want to address the steady rise in leverage within the stock market, as exemplified by the amount of margin debt outstanding. Since the February 2009 bottom, total margin debt outstanding has increased by 78%, and has retraced about 72% of its peak-to-trough decline from July 2007 to February 2009. Total margin debt outstanding increased by $6.4 billion during March—standing at $355.4 billion, its highest level since month-end February 2008 (right before the Bear Stearns collapse):
No doubt margin debt outstanding is now extremely elevated—and given the decline in global liquidity and the negative technical divergences we've covered over the last several months, we expect the short-term upside in the market to be extremely limited. Subscribers please stay tuned.
Henry To, CFA, CAIA