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Despite the recent correction, stocks remain significantly overvalued – at the second-most expensive level in history. While shares recovered almost half their -10.10% early-November correction last week, there is a strong chance that more volatility and lower prices are coming.

The Price/Earnings ratio is often used as a universal standard for valuing a market index or any investment that produces earnings or cash-flow. In other words, the P/E Ratio can apply to any equity, but not an earnings-less asset such as gold or residential real estate. Similarly, the percentage return from dividends on fixed income investments can be used as a standard to compare one to another.

The P/E ratio is a very straightforward measure of valuation because it is calculated from the asset's price divided by earnings. However, critics argue it also has some deficiencies, such as management's ability to manipulate earnings by 'adjusting' accounting line items such as depreciation and goodwill.

Some companies notoriously 'adjust' earnings to ensure they are profitable every quarter and are growing by an optimal amount relative to competitors. Various industries have unique variations on the P/E ratio that have been approved by regulators, and these variations and other subjective accounting approaches have led to infamous abuses such as those contrived by Enron and other notorious scammers

Even after the market correction, P/E ratios for all key stock market indices are quite elevated, with the S&P 500 (large-cap) index at 25.52 (its long-term average is 16.8). The current NASDAQ 100 index PE is 24.32, the Dow Industrial Index is at 26.2, while the Russell 2000 (small-cap) index PE is at the nosebleed level of 145.56. Also, the market capitalization of the S&P 500 Index is 150 percent of gross domestic product, well above the 2007 pre-crisis peak of 137 percent. 


A long-time criticism of P/E ratios is that they only reflect the earnings from the previous twelve months, so that fluctuations in earnings can significantly affect the P/E ratio.  A well-regarded alternative is the Shiller Cyclically Adjusted Price to Earnings Ratio (CAPE), named after Nobel Prize-winning economist Robert Shiller.  The Schiller CAPE Ratio compares the current price of an investment or index to the prior, inflation-adjusted, average 10-year earnings of an investment or index.

Chart 3 below shows the Shiller CAPE Ratio (aka, 'PE10') is currently at the extremely elevated level of 32.20. This level was only exceeded from January 1998 to its peak two years later in December 1999 at 44.20, the pinnacle of the dot-com bubble, which was followed by a crash. Previous to that, the highest level was in September 1929 with the CAPE at 30.6 and market immediately collapsed after that.


 Schiller CAPE ratio (PE10)

Chart 1: Despite the recent correction, the Shiller Cyclically Adjusted Price to Earnings Ratio (Shiller CAPE) remains at its second-highest level in history. Source: Multpl.com.



Investors should keep in mind that valuation is a poor market-timing indicator. While extremely high valuations will be a headwind that will ultimately cause a market to decline back to its long-term, median levels, high equity valuations are rarely the cause of a market selloff.  History shows that stocks can remain overvalued, while becoming even more progressively expensive, for prolonged periods of time. However, high valuations, while not a cause of a market crash, can often be a precursor of severe market selloffs.

Chart 2 below shows the history of the 15 bear markets since World War II for the S&P 500. A bear market (a -20% or more downturn) has occurred an average of every five years over that 70-year timeframe. Extreme valuations preceded most of these bear markets, but not all of them. In fact, several selloffs began with the P/E ratio and Schiller P/E ratio significantly below their long-term averages


Valuations before bear markets


Nevertheless, the chart shows that extended valuations preceded the vast majority of bear markets, which implies that when valuations get extreme, the danger of loss for by-and-hold investors increases.


Some analysts believe that because of historically low-interest rates, long-term average market valuations are not a good indicator for the current era.  They think valuations may have reached a new plateau and that because of this, stocks are not as richly priced as they would appear when compared to historical averages.

If you glance again at Chart 1 above, you can see that valuations are relatively higher since 1990 (marked with a red 'B') compared to their average over prior 110 years (marked with a green 'A'). Some analysts put the mean of the Shiller PE's recent era (since 1990) at 25, rather than the long-term average of 16.8 for the S&P 500.  Still and all, a Schiller PE of 32.2 remains nearly 30% above a 'new-era' mean of 25.

On the other hand, many market veterans would argue that the elevated valuation levels since 1990 are an anomaly related to steadily declining interest rates since 1980. Hitting a historic low of 1.37% in early July 2016, as of last Friday (February 16) the 10-year Treasury Yield has risen to 2.87%. Many believe that having come very close to the zero bound, and with inflation picking up (inflation is a significant influence on interest rates), we may be in a rising-rate environment going forward.

Therefore, the lofty average valuations since 1990 may ultimately revert to their long-term mean of 16.8 – which would imply that average valuations would need to be significantly below the mean for the next three or four decades to balance out today's current high average level at 25. Alternatively, altitudinous valuations may be here to stay for a reason other than low interest rates. Time will tell.


Many analysts expect the global economic cycle to continue through 2018 and even into 2019, making this the longest postwar economic expansion in history. Nevertheless, with valuations currently so high, many analyst forecast that market returns will necessarily be low for the next five to 10 years. One of two scenarios typically cause this circumstance; 1) the market stays relatively flat while the economy and earnings expand beneath it, bringing overall valuations down, or 2) a market crash ensues, bring valuations rapidly back to their mean.

That said, it's rarely one thing that causes a severe decline – markets usually die a death of a thousand cuts. The heightened valuations followed by the recent, sharp decline that reversed the low-volatility trade are just two cuts, and it will likely take many more. However, with the Federal Reserve now unwinding the Quantitative Easing program that provided easy money to the market for the last nine years, stocks could face as much of a headwind as they formerly experienced as a tailwind from that easy money. That counts as another cut or two.

In January, the Labor Department reported a 2.9% rise in hourly wages from a year earlier, and this prompted inflation fears that may have triggered the recent correction. That's another cut. After a while, those cuts add up, and the victim suddenly dies a miserable death when they bleed out.

It is too soon to tell if the recent correction was a blip in a long-term uptrend or the beginning of a more severe downturn. While our Trend Reversal Indicator is signaling that a trend change is imminent for S&P 500 stocks, that signal has not been given for small-cap stocks or medium-sized companies. However, significant technical damage was done during the rapid, two-week, -10.10% selloff. Rarely do we see the type of selloff event that occurred the weeks of January 28 to February 9 take place in a vacuum. We believe that the market is sending a signal that more volatility is ahead. 

So far, for each of our strategies, the 28-different time series that are analyzed each week are still providing an overall bullish signal and our ETF strategies are staying long with the most aggressive ETF positions. That will automatically change should these indicators become sufficiently bearish.


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