As recently as the November 2016 election, the S&P 500’s dividend yield (2.0%+) was higher than the 10-year Treasury bond’s yield (1.75%). Many exclaimed that ultra-low interest rates alone justified extremely high stock valuations, including a GAAP-based price-to-earnings ratio (P/E) of 25.
A year and a half later, the S&P 500’s dividend yield (1.8%) offers much less than the 10-year’s yield (3.0%) and struggles to compete with cash equivalents. Meanwhile, the benchmark’s GAAP-based P/E is still in the stratosphere at 24.3.
To be clear, stocks are still trading at valuation levels rarely before seen in history. On a wide variety of measures — market-cap-to-GDP, PE 10, Crestmont PE, Tobin’s Q, price-to-sales (P/S), price-to-book (P/B), 12-month price-to-earnings (trailing and forward) — 2018 valuations share a lot in common with 1929 and 2000.
Even the most favorable measure, forward non-GAAP price-to-earnings, would not intrigue a value-oriented investor. The S&P 500 would need to fall to the 2250 level to revert to its mean. That would represent a top-to-bottom bearish descent of 21.7%.
Keep in mind, however, stocks rarely fall from severely overvalued to fairly valued. They frequently overshoot; they typically wind up in undervalued territory. A 30%-plus decline to the 1950-2000 level for the S&P 500 would be far more consistent with bear market behavior.
Some folks believe that ultra-low interest rates may not be as important today because the corporate tax cuts picked up the stimulus baton. Not exactly. Tax cut euphoria for 2018 was accounted for in 2017. In contrast, Federal Reserve policy tightening is still a work in progress, and it will likely continue until a recession or crisis dramatically alters the central bank’s course.
Perhaps ironically, very few people believe that a recession or crisis is around the bend. Even more people seem to feel a recession will announce itself like Steph Curry returning to the Golden State Warriors basketball court.
What if, however, economic malaise is much closer than most think? For example, there is evidence to suggest that when consumer discretionary stock outperformance over consumer staples is two standard deviations above the historical average, economic contraction is likely to begin within a year’s time. This was certainly the case leading into the 2001 recession as well as the 2008 recession.
In a similar vein, key economies via gross domestic product (GDP) have not been strengthening. On the contrary. The tapering and/or removal of central bank monetary policy stimulus around the globe may be having an adverse impact.
There’s more. Consider inflation-adjusted credit growth. Since 1952, there were only 10 years when total credit grew by less than 2%. A recession came to pass on nine of those instances.
Why might total credit be a factor? Inflation-adjusted total credit only grew at 1.9% in 2017. Worse yet, inflation has been ticking higher such that credit is unlikely to expand at greater than 2% in 2018 or 2019.
Perhaps most notably, key yield curves are unusually flat. For instance, the private sector yield curve for the corporate credit market is already at zero. This is when the yield of long-dated Baa corporate bonds (seasoned) equals the prime lending rate that banks charge. Both approximate 4.75%. Indeed, some economists believe that if the private sector yield curve inverts, scores of companies will be forced to service debt and/or let go of employees.
Then there is the Treasury bond yield curve. Due to the fact that the Federal Reserve (a.k.a. “the Fed”) has hit inflation targets as well as employment targets, and due to the reality that the Fed needs to get the overnight lending rate higher to have some ammunition to fight a future recession, the short end of the yield curve is going to keep climbing.
In contrast, there does not seem to be a whole lot of movement in the long end of the curve. The 47 basis point differential between “10s” and “2s” currently implies a strong chance of inversion in the 2nd half of 2018.
What is the big deal with this yield curve stuff anyway? Inversion has predicted all nine U.S. recessions since 1955. (It’s not like the Fed does not know the data… the San Francisco Fed conducted the study.) It is worth noting that, after the yield curve inverts, the average length of time until the economy contracts is 11 months.
Naturally, there are those who plan to wait until the Treasury bond yield curve inverts before lowering their allocation to equities. That could be problematic. For one thing, nearly half of the stock bears in history occurred without a recession tie-in.
More importantly, yield curve inversion has “predicted” all nine U.S. recessions, but each occurred between 6 and 24 months afterwards. That is a pretty big spread. In fact, stock market depreciation itself may be a better predictor of recession since the reversal of the “wealth effect” may cause economic hardship.
David Rosenberg of Gluskin Sheff has a slightly different take. He notes that the 5.3% peak for the 10-year T-note in the summer of 2007 represented a 200 basis point change from the 2003 lows, dooming stocks in the 10/07-3/09 financial collapse. Similarly, the 10-year’s peak of 6.75% in 2000 represented a 200 basis point surge off of the Asian Currency Crisis lows from 1998. Rosenberg contends that the rapid 200 basis point change ushered in the 2000-2002 bear.
If one accepts Rosenberg’s premise about 200-basis point changes, a 10-year in and around 3.3%-3.4% may be the final blow. Or if we simply employ relative change, the doubling of the 10-year yield that occurred between July of 2016 and January of 2018 has already done the trick.
Indeed, it is possible that the stock market bull ended in January of 2018. As it stands, the current correction from all-time highs has lasted longer than any previous correction since 2008.
Long-time readers know that I reduce some stock and bond risk when fundamentals get stretched and/or technicals break down. Even longer-time readers and prior radio show listeners understand that my significant risk-off indicator is the monthly close on the 10-month moving average. The tool helped my clients sidestep the bulk of losses in the 2000-2002 tech wreck as well as the 2008-2009 financial meltdown.
For those who view occasional whipsaws as burdensome, the monthly close on the 12-month SMA may be more compelling. The red dots in the graph below show when you would have reduced stock risk.
In essence, you would have lessened your exposure in the 1998 Asian currency crisis, the 2000-2002 dot-com catastrophe, the 2011 euro-zone sovereign debt disaster and the 2015-2016 earnings recession. Using the same methodology, you would have achieved phenomenal risk-adjusted capital appreciation during the bull market portions of each bull-bear stock cycle.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.