Predicting the direction of the market can be done through observing and analyzing several indicators in relation to market return, including GDP, earnings growth, sentiment and interest rates. Extensive research has been carried out in this area, specifically analyzing the relation of the market to earnings and GDP. The predictory value of these studies, however, is not very high given the fact there is no standardized way to gauge whether the market is undervalued, overvalued or priced for perfection.
The price-earnings (P/E) ratio has been the most widely used indicator of market valuation in the stock market arena. This indicator, however, failed to predict market reversal. The S&P 500's P/E ratio was 18.36 during July 2007 and 28.50 during April 2000; the market started to plunge after these months respectively. This indicates that a rule of thumb P/E ratio might not be the right approach to market valuation given the stock market trades around a P/E of 26.28 as of April 2017 and the market is trending upward.
Quantitative easing: An indicator of market valuation?
The Federal Reserve, or Fed, balance sheet might provide a better explanation of stock market returns as compared to other conventional indicators like GDP and earnings. The rationale is quantitative easing can lead to excess reserves in the banking system that can be channeled to stock markets, boosting the markets.
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The Fed has been following an easing policy since the financial woes of 2008. The Fed has been aggressively pursuing the policy since 2009 and has been maintaining a relatively constant balance since 2015. The Fed kept loading the balance sheet through buying the securities from commercial banks, which lead to this unprecedented accumulation.
Tapering is problematic
The problem is that once the Fed starts to unwind the balance sheet, the pressure will shift toward commercial banking again as money is pulled from the markets. In turn, this can result in a market reversal. The flat balance toward the end of the above chart indicates the unwinding will not be easy as it can lead to disruption in the financial markets. That is why the Fed has been careful to unwind.
Price-earnings ratio is problematic
Price-earnings values are touted to be a premium market valuation indicator, but price-earnings ratios move randomly irrespective of market direction. The S&P 500's P/E ratio stood at around 18.02 when the market peaked in 2007; it stands at around 25.8 as of 2017 and the market is still rising. A ratio of 18 was expensive at that time, but it does not look expensive now. This is indicative of the fact that P/E ratios can only be used as a starting point for gauging market valuation levels.
On the other hand, if we look at the market from Fed’s balance sheet perspective, it makes more sense. The price-asset ratio has not fallen to the level of 2007 and 2008, indicating market prices are not as high as they were in 2008. A value of 400 proved unsustainable back in the day, but price-asset treads around a level of 800, currently depicting markets are not as high as they were back then. A look at the price-asset ratio charts below put it into perspective.
The price-asset ratio
It can be observed that stock markets are quite sensitive to the Fed’s balance sheet. This balance sheet data can be used as a pointer toward market valuation. One way to do that is to look at the relative values of the balance sheet and stock market composite. The comparison between the Fed’s position and Nasdaq composite follows below:
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The Fed introduced the program toward the end of 2008, which explains the spike in the ratio. Since then, the ratio has been falling despite the Fed's inflation of its balance sheet. This indicates market prices are increasing at a higher rate compared to the Fed’s balance sheet.
The point to note here is relative value of the balance sheet tends to predict market reversal. The value persisted at a low value of 400 during 2007 and 2008, indicating such low values are not sustainable leading to a market crash. Higher values are better as it can be seen that the market has been climbing since the introduction of quantitative easing programs and has not looked back yet. Therefore, looking at relative price-asset is useful in predicting overall market direction.
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The price-asset ratio has mostly stayed above two since 2003, and the market reversed when it surpassed a threshold of three. The Fed intervened to bring the value below one though expanding its asset base. The market has been moving in an upward direction since then. The price-asset value has not yet touched a 1.5 mark, which is almost half the value at which the price-asset ratio stood in 2008. The Fed's constant expansion of balance sheet kept the value hovering between 1 and 1.5. The point is that the Fed’s asset–market value ratio is a good indicator of market valuation and can provide pointers toward overvaluation.
Final thoughts
Based on relative analysis of the Fed’s balance sheet and market values, the market is affected by the rate and extent of monetary easing. The market moves upward as long as the Fed continues its expansionary policy. However, the converse also holds true as unwinding would result in increased price-asset ratios, leading to unstable prices. Therefore, keeping an eye on the Fed’s balance sheet is a good idea because tapering can affect markets adversely. As a rule, long-term investors should remain cautious once the price-asset value moves past two. Note that it can happen either if the Fed decides to taper or market prices follow an upward trajectory. Further, interest rate policy and tapering are two different things. The Fed may increase rates without introducing tapering and, despite the contrary belief, interest rate hikes will not affect market prices as much as tapering can. All in all, pulling out of the market would be a good idea once the Fed materially unwinds its balance sheet, or you can brace for impact.
About the data
Monthly data from Federal Reserve’s balance sheet during 2003-2017 was used for the analysis. NASDAQ composite was used as a proxy for market return. A regression analysis was done on the data revealing strong positive correlation between Fed’s balance sheet and NASDAQ composite. Price-earnings data was also analyzed, revealing insignificant correlation between P/E and market values. The Fed’s data was obtained from FRED economic data while NASDAQ data was accessed through Yahoo Finance. Regression files can be obtained on request.
Disclosure: I have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours.
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