The atmosphere is getting thin up here, and every ounce counts triple when you're climbing in rarefied air. While near-term market dynamics are more likely to be affected by Friday’s employment report than any other factor, our broad view remains that stocks are in the late-stage top formation of the second-most extreme episode of equity market overvaluation in U.S. history, second only to the 2000 peak and already beyond the 1929, 1937, 1972 and 2007 episodes, not to mention lesser extremes across history.
On the economic front, much of the uncertainty about the current state of the economy can be resolved by distinguishing between leading indicators (such as new orders and order backlogs) and lagging indicators (such as employment). It’s not clear whether the weakness we’ve observed for some time in leading indicators will make its way to the employment figures in time to derail a Fed rate hike in December, but as we’ve demonstrated before, the market response to both overvaluation and Fed actions is highly dependent on the state of market internals at the time. Presently, we observe significant divergence and internal deterioration on that front. If we were to observe a shift back to uniformly favorable internals and narrowing credit spreads, our immediate concerns would ease significantly, even if longer-term risks remained.
Having reviewed the divergences we observed across leading economic indicators and market internals last week (see Dispersion Dynamics), a few additional notes on current valuations may be useful.
As I’ve noted before, the valuation measures that have the strongest and most reliable correlation with actual subsequent market returns across history are those that mute the impact of cyclical variations in profit margins. If one examines the deviation of various valuation measures from their historical norms, those deviations are rarely eliminated within a span of a year or two but are regularly eliminated within 10 to 12 years (the autocorrelation profile drops to zero at that point). As a result, even the best valuation measures have little relationship to near-term returns but provide strong information about subsequent market returns on a 10- to 12-year horizon. Among the most reliable valuation measures we identify, those with the strongest relationship with subsequent 12-year nominal Standard & Poor's 500 total returns are:
- Shiller P/E: -84.7% correlation with actual subsequent 12-year S&P 500 total returns.
- Tobin’s Q: -84.6% correlation.
- Nonfinancial market capitalization/GDP: -87.6%.
- Margin-adjusted forward operating P/E (see my Aug. 20, 2010 weekly comment): -90.7%.
- Margin-adjusted CAPE (see my May 5, 2014 weekly comment): -90.7%.
- Nonfinancial market capitalization/GVA (see my May 18 weekly comment): -91.9%.
MarketCap/GVA is presented below to provide a variety of perspectives on current valuation extremes. The first chart shows this measure since 1947. We know by the relationship between MarketCap/GVA and other measures (with records preceding the Depression) that the current level of overvaluation would easily exceed those of 1929 and 1937, making the present the most extreme point of stock market overvaluation in history with the exception of 2000. In hindsight, the only portion of 2000 when stocks were still in a bull market was during the first quarter of that year.
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