Firstly, trailing 12m p/e valuation. This chart clearly shows this measure is a rather useless tool, and can be disregarded:
Source: D Short
Secondly, forward p/e (12m) valuation. This measure is based on expectations and guidance from companies and analysts. Under- and over-estimating is common for a myriad of reasons (some deliberate, some unrealistic), so this measure lacks reliability and produces another poor chart:
Thirdly, dividend yield valuation. Also a valuation measure with problems, due to companies increasingly having moved away from paying dividends in favour of share buybacks:
Source: Vector Grader
Fourthly, CAPE (or Shiller) valuation. Takes the last 10 years earnings inflation adjusted, and is much more reliable, with a 0.9977 historic correlation with the real SP500:
Source: D Short
By CAPE valuation the SP500 is in the 93rd percentile of all historic valuations.
However, the last couple of years have seen the real SP500 diverge from CAPE, suggesting an additional degree of exuberance is in play:
This is resolved by using, fifthly, the Crestmont p/e. Similar to the CAPE but uses a different method of normalising the EPS, which makes for an even tighter fit including that additional recent exuberance. By Crestmont p/e US stocks are in the 98th percentile historically:
Sixth, the Q Ratio. This is a totally different approach based on the market divided by the replacement cost of all its companies. It, however, produces a similar compelling result historically, and estimates stocks to be in the 97th percentile historically, cross-referencing with Crestmont:
Seventh: Market Cap to GDP. We can add in Warren Buffet’s preferred valuation measure as additional confirmation of the extreme historic over-valuation:
Using the level playing field of the CAPE measure, we can see how the US’s valuation stands up relative to other countries:
Source: Seeking Alpha
By this comparative measure, US stocks are again extremely expensive, almost the dearest in the world.
Now we need to draw in demographics. Here are treasury yields and SP500 CAPE versus their respective US demographic trends:
The implication is that market valuation has to be assessed in the context of demographics. An expensive market will get more expensive if there is a swelling population of the age that would buy stocks (or bonds), and vice versa.
US demographic trends argue for lower valuations ahead, lower real stock prices:
Therefore, the extreme valuations in US stocks, both relative to history and relative to other countries (with more favourable demographics) argue for a bear market. There is no demographic tailwind to take them to even higher valuations.
The question is, why have US stocks run up so far?
Is it the aggression and support of the Fed? If so, then with QE scheduled to end in October, the market should be readying to fall. But, as per my recent post, I rather believe ‘Fed policy trumps all’ has been the mantra for the mania rather than the driver.
Is it the relative economic performance versus Europe and Japan, including its progress from energy importer to exporter? The problem is that all that is priced into the valuations, i.e. price has nonetheless run up far beyond earnings.
Is it the safe haven perception of US equities and the US dollar? Perhaps.
Is it the propensity for US companies to equity buybacks or for US investors to draw on loans and margin, both propelling prices higher? Could be.
Or is it that US stocks began the process still elevated following 2000’s biggest mania of all time? The valuation charts show this to be so.
I believe I can explain the mania of the last 18 months with the solar cycle. The sunspot maximum has driven the speculation to take US equities to these dizzy valuations and cast doubt on the secular bear progression since 2000, as the current bull has been given an exuberant last leg into 2014’s solar max (see my recent Last 18 Months post). However, now that we are through the smoothed solar maximum, the combination of valuations (CAPE, Crestmont, Q ratio and market cap to GDP) and demographics argue for a new bear market at hand within an ongoing secular bear to take us to the kind of washout valuations that 2002 and 2009 so far failed to deliver. Rather, we have stair-stepped our way down since 2000 in alternating cyclical bulls and bears, and we can see this in other economic measures:
Source: D Short
Demographics and valuations both argue for another step (or even steps) down lower from here.
One more valuation measure to finish: we can look at US stocks pricing relative to commodities and relative to bonds. In both regards US equities are now at the same extreme relative pricing as 2000’s peak.
Therefore, by CAPE, Crestmont, Q ratio and market cap to GDP; by relative expensiveness to commodities and bonds; by relative valuation to other stock markets around the world; and all in the context of demographics: I believe US equities are very clearly a major SELL.