Again, a breakdown in market breadth accompanied by highly overvalued equity prices should be met with a decision to reduce one’s risk exposure. One does not have to short the market or seek to eliminate risk entirely. However, it is sensible to insure against the possibility of monstrous loss. What’s more, when improving market internals occur in conjunction with more favorable stock valuations – as they did in 2002 and 2009 – one can rebalance back to a target allocation.
So what are the circumstances for today’s valuations and today’s market internals? Not so hot.
As I mentioned earlier, the median price-earnings ratios (P/E) and price-sales ratios (P/S) actually surmounted the peaks at the end of the last two bull market cycles – the metrics went beyond the valuation peaks hit in 2000 and in 2007. Corporate earnings have now fallen from a height of $106 in 2014 to current levels of $95.4 on the S&P 500 for a 10% decline. They’ve fallen for two consecutive quarters and they are expected to fall in Q4 in what has been dubbed an “earnings recession.” The trailing 12-month P/E Ratio is 22.7, while the average since 1870 is 16.6. Meanwhile, the PE10 at 26 sits in its highest quintile, implying that equities are severely overpriced.
What about forward 12 month P/Es? Aren’t they still attractive? Although this “guestimate” methodology did little to help folks avoid the staggering losses of 2000 and 2007, the forward P/E of 17.2 right now is higher than it was in 2007 and it is well above the Goldman Sachs 35-year average (13.0).
Naturally, perma-bulls and buy-n-hold advocates alike have endeavored to paint a prettier picture. Just exclude energy from earnings per share. For that matter, exclude corporations with 50% or more of their profits coming from overseas, and the earnings picture brightens considerably.
Now how silly is the mistake of “Ex energy” or “Ex foreign exposure?” That’s akin to tossing the double-digit earnings expansion of the health care sector because the results are too wonderful. That’s about as sensible as removing the positive contributions from the consumer discretionary sector, since the savings at the pump have presumably gone into spending online or eating at restaurants or purchases at the auto mall.
Conjuring up “Ex energy” is like putting lipstick on an elderly pig or providing a face lift for an aging dog. (Yes… those politically incorrect references.) Remember, “Ex-tech” discussions were floating around in 2000. “Ex-financials” were popular with analysts in 2007. If you’re going to argue “Ex energy” earnings per share today, then you should have ran with this line of thinking when crude traded north of $105 per barrel.
Bottom line? It is true that valuations only carry weight when stock tailwinds turn to stock tornadoes; it is accurate that decidedly overpriced equities could thrive until they become insanely priced. Nevertheless, booms become busts and the current bull cycle is no different.
It follows that preparing for a bust involves monitoring the forces that drive valuations as well as monitoring market internals. For instance, we know that ultra-low borrowing costs over the last seven years have fueled everything from consumer purchasing activity to mortgage refinancing to real estate speculation to corporate share buybacks. The question an astute investor may wish to pursue is whether or not corporations will even be positioned to take on more debt to buy back their shares going forward. Total corporate debt has more than DOUBLED since pre-crisis levels of 2007, while the average interest paid on debt for corporations has jumped from 3.5% in 2007 to 4.5%.
That’s right. Corporations are paying more and more of the money they make/borrow to service TWICE as much debt at HIGHER interest rates than they were paying in 2007. Meanwhile, the Federal Reserve’s upcoming directional shift will make it more expensive to borrow new money in the bond market, hampering stock buybacks as cash flow from sales continues to decline.
For the time being, an allocation to S&P 500 proxies like the S&P 500 SPDR Trust (SPY) is holding up admirably. If you are over-allocated to riskier segments of the equity markets or higher-yielding bond markets, take your small gain or “tax-loss harvest” the small loss. Valuations for small caps in the iShares Russell 2000 ETF (IWM) are even more troubling than their larger-cap brethren. The rising price ratio for the iShares 7-10 Year Treasury (IEF): iShares iBoxx High Yield Corporate Bond (HYG) also indicates investor preference for perceived safety.
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