Credit Suisse is the latest bank to be rolling over … encouraging news from this morning’s PPI report … don’t count on a bull market just yet though … the valuation problem for stocks
This morning brought good news and bad news…As to the good news, the Producer Price Index surprised everyone by showing that wholesale prices actually declined in February. Estimates were for a 0.3% increase in prices. Instead, they fell 0.1%. Meanwhile, retail sales also fell 0.4% for the month. That was in line with expectations. This is welcome news for the Fed and its fight against inflation, and reduces pressure as it mulls its rate hike decision next week. Meanwhile, the bad news is that problems in the banking sector are intensifying. On Tuesday, Credit Suisse announced it had found “material weakness” in its financial reporting process from the last few years. This has already been a source of concern for not just Credit Suisse, but the potential domino effect on the broader banking sector. But then, this morning, the Saudi National Bank, which holds a 10% stake in Credit Suisse, announced that it would not provide any monetary assistance to Credit Suisse if problems snowball. This is troubling news primarily for the European banking sector. But given the interconnected relationship between multinational global banks, this is also concerning for U. S. big banks. It’s not a bad idea to spread your deposits over a handful of banks so that they don’t exceed the $250,000 FDIC insurance limit. Now, in light of the cooler PPI print and the banking chaos, there’s a reasonable takeaway:
The Fed is about to pause rates.
That could easily happen, yes.But that doesn’t mean we’re on the verge of a rip-roaring bull market. Let’s dig into this a bit more since there’s a growing narrative that “bad news is good news” means the Fed is done with its rate hiking, and that’s going to usher in the next great bull market. And to be clear, I’m not talking about a market that grinds higher, adding, say, 4% or 5% this year. I’m talking about a full-on, multi-year bullish extravaganza. Let’s see what some numbers tell us.
What history says about the beginnings of bull markets
Historically, our greatest rip-roaring bull market share one main characteristic…They begin when valuations are in the gutter. This makes sense. For a bull to enjoy a long life, it needs space and time to grow from a baby bull into a ripe, old-aged bull. One way to assess valuations is the CAPE ratio, which is the cyclically-adjusted price-to-earnings ratio. This indicator looks at a typical price-to-earnings (PE) ratio but uses earnings per share over a 10-year period, not just the past one year. This is done in an effort to smooth out business cycle fluctuations. So, what’s the relationship between CAPE values and bull market beginnings? My friend Meb Faber is a respected quant analyst who can answer that question for us. Below is a chart from Meb. Starting in 1900, the chart shows initial CAPE values and what the subsequent 10-year stock market returns ended up being based on those starting CAPE values. Dark green represents the cheapest CAPE starting years. Red represents the most expensive. As you’ll see visually, most of the “deep green” starting years (low CAPE ratios between 5 and 10) end up on the right side of the chart — meaning big 10-year returns. On the flip side, “red” starting years (high CAPE ratios between 20 and 45) usually end up on the left side of the chart — meaning low and negative 10-year returns. There are exceptions to every rule, but this dynamic plays out consistently enough to be incredibly helpful to a long-term investor. Don’t worry if you can’t read the data below. It’s more important to pay attention to the colors, with red on the left (high starting CAPEs) and green on the right (low starting CAPEs).
Given this data, what we can say is that the odds of a rip-roaring bull market increase when the CAPE ratio starts lower.So, what’s today’s CAPE ratio for the S&P 500? It’s 29. That puts it deep into the “red” bucket that includes CAPEs between 20 and 45. Clearly, this does not support the idea that we’re beginning a decade-long, rip-roaring bull market. Now, I know not everyone views CAPE ratio as a viable indicator. I disagree, but okay. Forget CAPE. What about just the plain ol’ vanilla PE ratio?
Can we expect a raging bull based on the normal PE ratio?
A few years ago, the research shop Bespoke analyzed bull markets since 1942 and found that the average bull market begins with a starting PE ratio of 13.1 and ends with a final PE ratio of 18.9.From a median perspective, the starting PE drops to 11.7 and the ending PE drops to 18.7. And where’s the S&P’s PE ratio today? 21. In other words, it’s not just that the S&P isn’t trading at a valuation that’s on par with average bull market beginnings, the S&P’s current valuation is richer than when most bull markets die.
“But Jeff, capital market structure has changed since 1942. PE levels now come in much higher than they did in the past so your argument is outdated.”
Okay, let’s look at this a different way.
The bull market coming out of the Great Recession in 2009 was the longest bull market in U.S. history
And what was the relationship between the PE ratio and the returns of this epic bull?Well, according to data from Guru Focus, the S&P’s PE ratio hit its low around 13.88 in October of 2011. The S&P did not reach a PE ratio of 21 (the current PE ratio) until April 2015 — three-and-a-half years after the bull began. As you can see below, from October of 2011 through April of 2015 the market return was about 84%.
Now, if an investor came late to the party and wanted to hop on the greatest bull market in U.S. history when its PE ratio had hit 21, what was the result?Well, let’s take our analysis up until October of 2018. We’re stopping there because as you may remember, the S&P fell 20% from October through Christmas Eve thanks to the Fed’s tightening policy. That 20% fall is an official bear market. Let’s say we timed it perfectly and got out in early October. As you can see below, the S&P’s return from May 1, 2015, with a PE of 21, to its October 2018 high was only 40%.
Now, a 40% return over about 3.5 years is good. I’d take that.But it’s certainly not as “rip-roaring” as the 158% return an investor would have enjoyed had he invested in October 2011 when the PE was 13.88 and held until this October 2018 high. Bottom line: Starting valuations matter. But let’s lower our bar now… Could we be on the cusp of 40% returns over the next few years? Well, that’s certainly more realistic. But there are big differences between last decade’s bull market and today.
A comparison between “then” and “now”
Let’s look at three differences.Clearly, a huge difference is the CPI. Today’s inflation towers above the sub-2% inflation that marked nearly the entire post-2009 bull market. In fact, the average CPI from January 2011 through December 2018 was closer to 1.5%. Yesterday, it came in at 6%.
Next, let’s look at the unemployment rate.Unemployment is near record lows today. And while that might appear to be a good thing on the surface, it’s the opposite. When nearly everyone who wants a job has a job, there’s only one way for this dynamic to go… The wrong direction. See for yourself. The post-2009 bull market started with elevated unemployment that gradually decreased. Today’s unemployment rate clocks in at the level at which the 2009 bull market ended.
Finally, what about the profit margins of the companies in the S&P?Below, we look at a chart showing the S&P’s Gross Margin, Operating Margin, and Net Margin beginning in October 2011, extending through January of this year. The takeaway is that all three margin readings are much higher today than back in 2011.
So, what do all these data tell us?
I’m not making the case the stocks are about to gap lower. I’m also not claiming that the market can’t grind higher.The PE level is expensive but not nosebleed… inflation is high but falling… unemployment numbers can remain low… pressure on S&P profit margins is elevated but has eased… All of this could support some stock market gains. But these data don’t support the idea that we’re beginning a broad market, decade-long, rip-roaring bull thanks to a Fed that’s about to do a U-turn. But… This doesn’t mean you have to avoid the market. Our InvestorPlace analysts are zeroing in on specific corners of the market that they believe offer return-firepower, even if the S&P itself doesn’t. For example, Louis Navellier remains incredibly bullish on top-tier oil and gas stocks. Luke Lango has been urging investors to put money into beaten-down technology innovators. And Eric Fry is positioning his subscribers in companies that are leading a Renaissance in U.S.-based tech manufacturing. While the data suggest we’re not in a “rising tide lifts all boats” market, that doesn’t mean certain “boats” can’t do very well. You might think of our investment environment as “big picture cautious, small picture opportunistic.” Now, in tomorrow’s Digest, we’ll profile one such opportunity that’s been seeing a host of triple digit winners over the last year. Have a good evening, Jeff Remsburg