Finally! It’s happened. The SPX has blasted through that wall of worry and risen through last May’s all-time high. Investors are willing to pay more for stocks even as earnings and growth cascade downward. Chart-chasers pile into risk assets on the fear of missing out. If one were to take a step back from the outright denial, they would see a market that is overvalued and overhyped.
The pressure to perform can get the best of us and, usually, at the worst of times. We are witnessing funds pour money into ETFs in an attempt to bring their performance to break even, while mutual funds continue to experience outflows. Traders are now chasing the markets, and that is a problem.
Are you bullish at the current all-time high? Because if you are, it’s likely you were on May 21, 2015. And what is the performance of the SPX from the May 2015 high to current levels? 1.70 pecent or 10 bps more than the current U.S. 10-year yield. (SPY YTD gain 3.82 percent vs. TLT 16.35 percent).
Let’s take this back a little further, shall we? Those that got uber-bullish on July 9, 2007 witnessed an 11.47 percent decline following the Bear Sterns liquidation, and, to disbelief, the SPX rallied and eclipsed the previous peak by 1.48 percent before falling 57.59 percent during the Great Financial Crisis.
Are we on the verge of another financial crisis? Potentially, but what is clear is that the current valuations and mispricing of risk is leaving many open to the Taleb distribution. Investors are piling into a crowed trade trying to etch out a few percentage points while leaving themselves open for a catastrophic risk event that would wipe out any unrealized (and realized) gains.
How overvalued is the SPX?
At 25.03x trailing-times price-to-earnings, the SPX has only seen these obscene valuations twice, near the panic of 1893 and the Dot Com bubble, according to multpl.com data going back to the 1800s. Currently, the SPX is within the 99 percentile of how expensive equities are, and the index TTM is 10 points above historical levels.
The Shiller P/E, which is an average of inflation-adjusted earnings over the last 10 years, is currently 26.96, a level not seen since just prior to the 2008 financial crisis. Essentially, this is indicating that future returns will be lower than average over the next 10 to 20 years.
To put this in perspective: the Shiller P/E median is 16. The SPX is currently in above the 93 percentile.
The earnings growth rate is horrid at -15.42 percent (Q4-15), while is only matched by the short recession following the Dot Com bubble and the 2008 financial crisis. It’s not likely to get much better this year. And, forget what the financial media tells you. It’s not just the energy sector:
Moreover, companies have to result to gimmicks and one-off exemptions to fool the general public into thinking earnings are actually growing and stocks are cheap. For instance, the non-GAAP P/E came in at 16.5x while the GAAP P/E was 21.5x. This is the kind of tomfoolery that also took place in 2007 and 2008. The financial media will refuse to discern the difference between the two.
There has been a decline in year-over-year (YoY) earnings growth over the last six quarters, following the all-time profit bubble-high in 2014. Following Q1-16 earnings decline of seven percent YoY, the consensus expectations of full-year earnings growth of 13 percent is quite ridiculous.
Of course it’s all back-loaded to Q3 and Q4 in order to follow the paradigm of extend and pretend. In order to reach consensus estimates, the earnings are forecasted to grow seven percent YoY in Q2, 19 percent YoY in Q3 and 37 percent in Q4. Quarterly earnings in Q3 and Q4 would have to eclipse $30 per share, far outpacing the Q3-14 record.
The forward P/E remains elevated at 17.4x. This metric of future earnings has come down substantially but only because earnings have been so poor. At current levels, it is still over two deviations above the 5- and 10-year mean, according to FactSet.
With the over half of the SPX earnings coming from overseas markets, the crimped global growth outlook remains key. Europe and other developed economies are stagnating, while emerging markets are no longer the drivers of growth they once were; and China is just an economic basket case.
The bulk of economists have been pushing the reality aside for a dreamier outcome. Energy earnings are always the scapegoat, but if we dive into the earnings of Q1 we see a different picture:
If we are ex-energy, the growth picture is meager at best. Financials – a Wall Street favorite – saw earnings down over 14 percent, and the flattening yield curve is not helping. Materials and industrials were down almost 8 percent and 16 percent, respectively. Technology was down 9 percent while utilities were down almost 2 percent, earnings-wise.
The winners in the last quarter were consumer discretionary, consumer staples, healthcare and telecommunications. This means 60 percent of SPX sectors were negative.
What is also in the growth picture is residing in the ICU. All cyclical sectors that trend higher in a strengthening economy are lagging severely, yet sectors investors go to as a defensive strategy during an economic downturn are performing as they typically do.
How overhyped is the SPX?
Despite all the talking heads depicting equities as historical valuations and a screaming buy (or worse, a “hold your nose and buy”), there is no conviction in the melt-up rally. One would expect volume to increase into these rallies stating that there was conviction in the move higher, but that’s not the case.
Our own research has shown that the opposite is the case. Volume is twice as great during a correction and four times as great during the initial sell-off. This suggested that even as equities are overhyped as buys, it doesn’t stop the market participants from jumping ship when things get dicey.
As risk discounting continues, the mere reappearance of already known, but ignored, market risks will erase that 1.70 percent gain traders fought oh-so hard for.
The mere fact that the SPX continues to levitate on multiple expansions is a precarious position to be in as a bull. U.S. corporate profits are now negative year-over-year for three straight quarters, and Q3 will probably be the fourth, since falling from the 2015 YoY high.
Each time this has happened, the SPX fell at least 20 percent.
I’m funny, how? Funny like I’m a clown – I amuse you?
Despite the clear bear case for the SPX, it seems almost laughable. I get flak all day long and maybe with reason. The SPX continues to head north, but I’m not here to play the nuances day-to-day. I’m not here to sugarcoat or point out that the broader hedge fund complex has underperformed the SPX every year during the greatest central bank intervention the world has ever known.
But, what I am trying to point out is that the combination of a U.S. business cycle rolling over, weak consumer base, dire world trade, and little to no global growth is not something to perk up one’s interest at these levels.
You may not pay your money manager absorbent fees to sit on cash, but you also don’t pay them to lose your money.
On March 26, 2015, I warned of a topping process in the Dow Transports, which began to fall shortly after. Then, on July 22, 2015, I doubled down on my bearishness and said the SPX was in danger of rolling over and bulls were in a risky place. Talking heads on the TV thought ideas similar to those were asinine.
32 days later, both indexes collapsed 14 percent and 12 percent, respectively, after the People’s Bank of China devalued the yuan. This was something a few saw, but I had been warning about the ongoing weakness in the Chinese economy since late 2014.
Central banks came in to recuse the markets, as they tend to do. That following October, I wrote notes indicating that not only would the transports index test the August lows but test the 2011 and 2009 trend lines on gaining downward pressure.
Another note shortly after pointed out junk bonds was beginning to roll over and would drag the SPY down with it.
If readers only heeded my warnings, they would have avoided the transports crash through the 2009 trend, junk yield spread gap over 1000 bps, WTI crude crash through my $27/bbl target set the following August, and the worst start to a year in U.S. equities ever!
Even within the last month as the markets thought the recent Brexit vote was a done deal and rallied vastly, I warned that the markets were “setting themselves up for a risk-off event.” Well, we knew what happened next and knew it would be a central bank picking up the broken pieces of Wall Street egos.
Current SPX price expansion on a longer duration chart is quite remarkable. With a z-score of 2.47, price action on the weekly chart has only been this over extending once when the index was making its first initial all-time high in 2007. The monthly z-score is moving towards 2, while both the 20 percent fall in 2011 and the 50-plus percent fall during the financial crisis all had levels over two or great (+/- 2 is a great contrarian indicator).
The point of being bearish simply doesn’t mean I, or you, would go out shorting everything. What it does mean is taking a step back in order to figure out how the complex pieces align, find where risk and prices are misrepresented and take advantage of them.
It’s perfectly fine to step away from the herd and reevaluate and not get caught up in the day-to-day shenanigans.
It doesn’t matter whether you make money over the course of the next week, year or even two years. For those who want to maintain and grew their wealth, it matters what happens over the next five, 10 and 20 years.
There are no bad assets, just bad prices.
With a decade in FICC, Chris Lemieux brings a unique blend of cross-market analysis, macro strategy and contrarian thought in developing forecasts. Often outside consensus, Chris has been able to deliver huge predictions in this dynamic market environment. Due to his uncanny accuracy – and a forthright approach – his analysis and forecasts see widespread distribution and commentary.
As the co-founder of MacroView Research, Chris upstands dynamic markets must be met with dynamic analysis and rigorous processing. MacroView strives to understand what’s happening in markets and how it can impact investors. You can follow him on Twitter at @.
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