David Moenning

About the Author David Moenning

David Moenning is a the Chief Investment Officer at Heritage Capital, which focuses on active risk management of the U.S. stock market. Dave is also the proprietor of StateoftheMarkets.com, which provides free and subscription-based portfolio services. Dave began his investment career in 1980 and has been an independent money manager since 1987. Thus, Dave has been live on the firing line and investing for a living for more than 25 years.

Will Valuations Throw Cold Water on the Bull’s Party?

In spite of the escalating trade “skirmish” and a long list of purported negatives, stocks continued to trudge higher last week with the DJIA finishing at a new all-time high on Friday. The S&P 500 wasn’t far off the pace, closing just 0.04% off Thursday’s record high. However, for the rest of the major indices, that’s where the good news ended.

The bottom line is there are short-term divergences developing in the major indices as those seeing Ms. Market’s glass as half-empty point out that the “troops” may not be following the “generals” at the present time.

Let’s start by looking at the good stuff on the chart of the Dow Jones Industrial Average (aka the original “generals” of the market)… Can you say “good times?”

DJIA – Daily 

As the saying goes, the most bullish thing a market can do is make new highs. ‘Nuff said.

Next up is the S&P 500. While the Dow is romping to new highs, the action in the primary blue-chip index is not quite as encouraging. My take is good, but not great.

S&P 500 – Daily 

Now let’s move on to the “troops”. As the chart of the NASDAQ indicates, the market’s long-term leaders do not appear to be following the Dow and S&’s lead. This week’s sector rebalancing as well as some possible rotation away from the FANG’s looks to be taking it’s toll.

NASDAQ 100 – Daily 

Then there are the small-caps. When you compare the charts of the DJIA and the IJR since the beginning of September, you have what amounts to a textbook example of a technical divergence.

iShares S&P Small-Cap (IJR) – Daily 

So, the first point I’d like to make on this fine Monday morning is that technical divergences CAN become problematic for the overall market over time. Not always. But, should the current divergent trends continue, our furry friends in the bear camp suggest that things may not end well for the bulls.

However, it is also important to note that short-term divergences are fairly common and may not last long. As such, it is probably not a good idea to run and hide at the present time due to the fact that small-caps are trending down slightly while the Dow is making new highs.

Can The Bulls Keep It Going?

The bulls point to the weekly charts of the Dow and S&P and ask simply, what’s not to like? As such, the question of the day seems to be, how much higher can the current bull market run?

Obviously, nobody knows the answer to this question. Nor will I offer up an opinion on the subject. But I can say from experience that aging bulls tend to cause the bears a fair amount of pain as they often persist much longer than our furry friends can imagine.

While I’m not in the prediction business (sorry), I do believe that looking at some macro indicators can help determine whether or not the bears might wake up from hibernation sometime soon.

As I opined in last week’s missive, entitled The Good, The Bad, and The Ugly, the economy, earnings, the labor market, and the state of the consumer lead the list of fundamental positives.

But if you asked 10 analysts to offer up their biggest negatives, I’d be willing to bet dollars to donuts that stock market valuations would be on every list. And since there has been a LOT of discussion on this recently, I’m going to spend the rest of my pixels this morning on the subject.

The Issue of Valuations

First up, I saw several references to the Price-to-Sales Ratio last week – which I highlighted as well in last week’s report. The key point here is that the P/S Ratio recently exceeded the levels seen in 2000. Yikes.

Frankly, the folks yammering on about this stat are a bit late as my data shows the P/S, as well as most other traditional metrics, currently backing away from their recent highs. But, when looking at the Price-to-Earnings, Price-to-Dividend, and Price-to-Book Value indicators from a long-term perspective, there can be no arguing that all are at historically high levels.

Yet at the same time, it is also important to note that these metrics have been improving for much of the year. For example, as you are no doubt aware, the “E” in the P/E ratio has been “movin’ on up” in 2018. And since price hadn’t really done much until late summer, the P/E ratios have actually been trending lower.

As Exhibit A here, I offer a long-term chart of the S&P’s GAAP P/E Ratio – which is the P/E ratio using generally accepted accounting principles instead of the traditional earnings Corporate America reports on a quarterly basis (which tend to involve a fair amount of “financial engineering” and a bunch of non-recurring stuff that seems to show up with remarkable regularity).

S&P 500 GAAP P/E Ratio

As you can see, the recent trend of the GAAP P/E is down. In short, this is good news if you are a stock market bull.

But the real question is whether the current readings are at extreme levels, which tend to give the bulls the edge, or something a bit less scary?

A Matter Of Perspective

From my seat, this is really a matter of perspective. As in, what time-frame are you looking at?

In the chart above, it is clear that the GAAP P/E remains well above the “Expensive” line (as determined by Ned Davis Research). However, this chart goes back into the 1920’s. And as many bulls like to say, should we really be comparing today’s market with anything that occurred before computers ruled the roost?

So, if you are bull or the manager of a mutual fund that, by prospectus, is required to stay nearly fully invested at all times, you may decide to change your “perspective” a bit. To something like the last 20 years. After all, 20 years is a pretty long time, right?

To help with this exercise, I’ve outlined the last 20 years in each of the charts in blue.

Now look at the GAAP P/E chart again. But this time, look only at the readings within the blue box. Voila. Suddenly valuations are not extreme. Heck, they aren’t bad at all.

Next up, let’s look at the Median P/E ratio, which looks at the P/E of the median stock in the S&P 500. I like this approach because it zeros in on the median stock within the S&P 500 instead of using the average of all stocks.

S&P 500 Median P/E Ratio

Looking only at the data contained in the blue box, the median P/E appears to be a bit above the average over the last 20 years. While not cheap by any stretch, the point is the ratio isn’t in nose bleed territory either.

Finally, let’s look at NDR’s “Normalized Valuations” Model, which looks at long-term averages of six independent valuation indicators based on dividends, earnings, cash flow, sales, inflation-adjusted P/E and trend.

Normalized Valuation Model

Looking at the entire series back into the 1920’s, it is clear that stocks are currently at one of the most overvalued levels in history. And THIS is what the bears are fussing about.

But looking only the last 20 years, the picture is quite a bit different. While the model suggests that stocks definitely aren’t cheap, they are also not at the extreme levels that the nattering nabobs of negativism have been screaming about.

The Bottom Line

There can be no arguing that the traditional valuation metrics are elevated relative to historical levels. But, depending on the time frame being used, one can argue that the market is not currently “extremely” overvalued.

Frankly, this approach to the valuation subject reminds me of an old saying… “There are three kinds of lies. Lies. Damned lies. And statistics.”

But at the same time, there is an awful lot of money in the markets that is not “risk managed.” Think about the trillions allocated to passive investing and the money that is simply automatically invested each month inside of 401K programs. This money is going to continue to be invested in stocks (well, up until it isn’t, of course). But until then, I believe the passive craze suggests that another old saw may apply here: Valuations don’t matter until they do – and then they matter a lot. And for now anyway, they don’t seem to matter too terribly much. Party on, Wayne!


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