First, I want to make this clear that this is not a market call. Equities may bounce or continue to correct; this below covers equity market considerations for the next 3-5 years
There is nothing in here that is really original; I have tried to leave out “my take” as much as possible and just post data. About half of the data below was published in my previous post but I decided to dig a little more and cover as much as possible in this post as well as look at some longer term data
This follow covers:
- Tobin’s Q
- Fed Model via Cliff Asness (AQR)
- Grinold Kroner
- Long Term US Equity Market Indices
- Sentiment - % Bear, Bull/Bear Ratio, Margin Debt
- Breadth - NYSE, MSCI Ex-USA,
- Insider Selling
- Cycles - January Barometer, Presidential Cycle, Kondratieff Wave
- What do the “experts say”? Sellside versus the buyside
The Q ratio has received a lot of attention lately, and there is a really good article at:
- “This metric is more appropriate for formulating expectations for long-term market performance. As we can see in the next chart, the current level is close to the vicinity of market tops, with Tech Bubble peak as an extreme outlier”
Could the ratio continue higher, to 2000 levels? Possibly, but no one disagrees that equities were in a bubble then and I think it is highly unlikely that a second bubble of that magnitude could occur. We don’t have to be in a bubble to be overvalued.
The next chart lines up the Q ratio with the S&P. What are forward looking expectations at these levels?
The full article where I clipped this chart from is below, and again I think one should read it as again it’s quite good (these are the only two articles I am suggesting). Again I’ve included a few quotes
“Except for relatively brief windows during the late 1920s, the late 1990s, and the mid-2000s, Shiller’s CAPE ratio has never been as expensive as it is today”
“A quick look reveals that the S&P 500 is the second most expensive stock market in the world today on both an absolute and a relative basis, second only to that of tiny Sri Lanka.”
While somewhat amusing, Chris Kimble of Kimble Charting Solutions presents a very serious question.
“The impressive thing about US stocks is not simply that positive sentiment and Fed liquidity continued to drive valuations higher, but that the market rallied as much as it did with very modest earnings in the face of historically dangerous valuations. I have said it before, and I will say it again: Sentiment, rather than fundamentals, is driving the US stock market, and sentiment can quickly reverse.” – dshort.com
Fed Model via Cliff Asness (AQR)
The following is from Cliff’s 2005 paper “Rubble Logic” published by the CFA Institute. The point that is illustrated quite clearly in the graph is that periods that began with the lowest interest rates had the lowest (negative) returns over the next ten years.
“Figure 6, which draws on Asness (2003), shows each month from 1965 onward in one of five buckets based on the level of interest rates that month. So, Bucket 1 represents the months where Y ended in the bottom 1/5 of all months (very low interest rates), and Bucket 5, the top 1/5 (very high interest rates). The dark bars represent the average real return of the stock market for the prior 10 years before the month in question. The result is the stuff of Fed Modeler dreams. When interest rates were low, the stock market, on average, performed phenomenally (more than 10 percent above inflation). This relationship is monotonically declining, ending in a paltry average real return of 2 percent when interest rates were at their highest. There is only one small problem: The dark bars are 10-year periods ending in either low or high interest rates. The white bars represent average real returns over the next 10 years. They are completely backward from a Fed Model perspective. Future real returns rise as interest rates increase. The average real return on the S&P 500 when starting from the lowest interest rates is actually negative. Looking forward, the best time to buy stocks is actually when interest rates are high. It is, if you will, an Anti-Fed Model.”
One way we can look at 2013 equity returns is through the Grinold Kroner Model
The output of the model is basically driven by the last three factors; real growth, stock buybacks, and PE expansion/contraction. When we examine those factors we know the following:
- Margins are at record highs; maintaining this going forward will be extremely difficult
- PE expansion was a significant part of 2013 S&P returns. Earnings are estimated to have grown 5-6% over the, the S&P was up ~30%
- Stock buybacks are at the second highest level, second only to 2007
The below chart is about a year old, but I’d be willing to bet that a more recent chart would present the same, if not higher readings
So where are the returns going to come from? All three drivers were at record highs!
It’s tough to argue that Japan didn’t contribute to the 2013 US equity market rally. Can we expect it to continue however? I can’t tell you that, but I can tell you that the Nikkei remains in its secular bear market and has thus far put in a bearish reversal at resistance
The Yen is also in a longer term uptrend despite selling off last year.
Yen and the Nikkei charts together
Long Term US Equity Market Indices
I wouldn’t necessarily bet the bank on any of these charts individually, but collectively I think they need to be considered
Dow 100 year
Dow 20 year
- brushing up against upper trend/resistance depicted in longer term chart above
- brushing up against upper trend/resistance
NYSE 25 yr
- Previous support becomes resistance
NYSE double top?
- Almost identical reversal candlesticks corresponding with a double top
Then there’s the S&P. No resistance lines to chalk up; just a “healthy” parabolic curve.. (note the sarcasm)
ZeroHedge illustrates the parabolic curve better (as it does all things bearish)
As Chris Kimble points out, one shouldn’t ignore the recent bounce in treasuries..
- Record level of bears reached last month, <15%
- Highest level since 1987
- Confirms what is being displayed in polls
Versus stocks over their 200 day simple moving average (divergence)
Last time such a divergence happened (2007)
While the drop in breadth is somewhat “steeper” in the 2007 chart, the divergences are approximately the same. The 2013 uptrend is much stronger than the 2007 uptrend, hence it would be difficult to imagine the breadth chart dropping off to the same extent. The next higher high or lower low in the breadth chart should give an indication of near term direction.
I view the below chart as an indication of breadth. While it’s certainly possible that the US can outperform the rest of the world the divergence over the last three years is significant.
How about just the US and its two closest trading partners, Mexico and Canada?
Obviously there are significant differences between the US, Canada, and Mexico, and the US has arguably been stronger. But how much are you willing to pay up for growth?
Below is what insider buying and selling looked like in 2009. Note that the highest reading is ~20 and for the most part the indicator remained in “bullish” territory (below 12)
Now look at the most recent chart covering 2013. The indicator has distinctly moved out of the bullish region and has had multiple bearish spikes, culminating with the most recent spike that is literally off the chart in the 2009 version above . This most recent spike coincides with the highs thus far experienced in the S&P 500.
In the hierarchy of considerations these are probably towards to bottom of the list, but important none the less (there’s a reason why they’re well known; they’re statistically significant; “sell in May and go away” didn’t work last year, but it did work the three previous years for example…)
This is a shorter term (one year) indicator via Ryan Detrick at Shaeffers, so perhaps not as useful as others for a long term outlook, but noteworthy for 2014
Note the average and mean return when the Dow is down 3.5% or more in January.
Again a shorter term consideration, but still relevant. Year two (current year) is by far the weakest. On the flip side, three and four are strong
In all the research I looked at, the only thing that is remotely bullish is that the presidential cycle suggests 2015 and 2016 could be strong.
I imagine this final “cycle” will be subject to much criticism, and that’s fine. I think the important thing to note is that the bull market that ran from 1982 – 2000 is far from “the norm” in which a lot of “long term” capital market implications are derived from. Looking at just the last century where data is more reliable we see that:
- 1900 – 1920 flat
- 1929 – 1950 flat
- 1966 – 1982 flat
- In total three time periods, corresponding with 57 years of the 19th century, were flat
What do the “experts” say?
Without getting into specifics (due to confidentiality) all I can say is that most of the sell side research suggests expected long term equity return between 7 – 7.5%. The buy side, those who are paid to make macro calls rather than to sell research; are much less optimistic. Ray Dalio of Bridgewater, for example, went on the record a couple months ago suggesting long term equity returns of 4% going forward.
- Tobin’s Q at levels that have coincided with secular bear, not bull markets
- CAPE at levels that have coincided with secular bear, not bull markets
- Fed Model suggests negative returns going forward
- Grinold Kroner model presents poor prospects for continued returns
- Major resistance for both the Yen and the Nikkei
- Many of the major US indices are at major long term resistance
- Sentiment at bullish extremes, as is margin debt and total net free credit
- Breadth has been deteriorating over 2013, similar to that of 2007
- Insider Selling hit its highest level in January in years
- Cycles are bearish
- Buyside much less optimistic than the sellside
Let me sum it up in with one final thought: QE is ending and sentiment hit extreme bullish readings, except with insiders; they are selling more than ever…
I would like to acknowledge a number of sources for this article:
- Kimble Charting Solutions – Valuable perspectives with some humor incorporated; lots of credit to this man, his charts are visually much better than mine, and accordingly I used quite a few (all contain his “Kimble Charting” logo)
- dshort.com – Q Ratio
- Ryan Detrick @ Shaeffers – Great source of quantitative data, used his “January Barometer”
- Zerohedge – Despite the overwhelming bearishness of this site, there’s lots of high quality info
- Mauldin Economics – CAPE
- Investors Intelligence – Bullish Poll charts
- Birinyi Associates
- AQR – Fed Model
- Barrons – Insider Selling
- The CFA Institute – Grinold Kroner
- Longwave group – Kondratieff Wave
If I’ve missed someone or you feel I have misused your work, please do not hesitate to contact me.
I would also like to point out I made a bearish call earlier in 2013 that I published on Seeking Alpha. While I think the initial work I did was quite good and accurate, I acknowledge I anchored myself to my original position and failed to give proper weight to other considerations after the fact. I am a student of the markets making plenty of mistakes but learning a thing or two while doing so.
- Brennan Basnicki