Stock Markets Ripe for a MAJOR Selloff – Here’s Why (+2K Views)

(NOTE: This post is presented by  Lorimer Wilson, editor of  www.munKNEE.com and the free Intelligence Report newsletter (see sample here). The article may have been edited ([ ]), abridged (…) and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read.

Hamilton goes on to say in further edited excerpts:

…As the U.S. stock markets keep on levitating, the bulls continue to rationalize this inexplicable melt-up by claiming stocks are still cheap.  They use this as a justification to buy high – but is this true?  Not by a long shot!  Today the U.S. stock markets are just as expensive in classic valuation terms as they were back in late 2007 when the last cyclical bull topped.  That led to a brutal cyclical bear, the same risk faced today.

When investors talk about stocks being cheap or expensive, they are referring to valuations.  This concept reveals how any individual company’s stock price compares to its underlying earnings or dividends.  Since the only way to multiply capital in the stock markets is to buy low and sell high, prudent investors want to pay as little as possible in stock price for each dollar of profits.  So they carefully watch valuations.

The most common and most important valuation measure by far is the classic price-to-earnings ratio.  It is as simple as it sounds.  It takes any stock price and divides it by that company’s annual earnings per share.  The resulting P/E ratio shows how expensive that company’s underlying profits are.  A P/E ratio of 20x, for example, indicates that each $1 in annual profits costs investors $20 in stock price to purchase.

P/E ratios are such intuitive and powerful money-making tools that they have been around for centuries, if not longer, and at least since the 1800s, the average P/E ratio of the broad US stock markets has been 14x.  Fourteen times earnings.  This average is certainly not arbitrary, it is a logical and fair rate to bring savers and debtors together to transfer scarce capital.  The reciprocal of 14x earnings is a 7.1% yield.

If you’ve worked hard and saved some of the surplus capital from your labors, you’d certainly consider lending it out at 7.1%.  In today’s Fed-manipulated zero-rate environment, that sounds fantastically high but it was normal for centuries and, if you were running a business that needed capital, you’d normally think paying a saver 7.1% for the use of their surplus would be just.  7.1% is a fair market-clearing rate.

The stock markets have long oscillated around 14x earnings in great third-of-a-century cycles I call Long Valuation Waves.  Sometimes investors fall in love with stocks and grow greedy, so valuations are bid up much higher than 14x, and other times investors can’t stand stocks so capital flees in fear, driving valuations much lower than 14x – but these extremes always ultimately mean revert back to 14x, so 14x truly is the absolute fair value for the broad stock markets.  The farther above 14x earnings the more expensive they are, and the farther below 14x the cheaper they are.  Today the S&P 500 stock index component companies are averaging P/E ratios of about 21.5x earnings.  That’s certainly not cheap like the bulls claim, it’s actually quite expensive…

This first chart looks at our monthly P/E-ratio data for the S&P 500 over the past 13 years or so.

• The simple P/E ratio is rendered in light blue and
• the superior MCWA one in dark blue.
• On top of these valuations the raw SPX itself is shown in red, and
• where this index would be trading at its long-term fair value of 14x earnings is shown in white.
• Finally dividend yields multiplied by 100 are drawn in yellow.

Let’s start with the red SPX itself.  Notice that despite all the bullish hype and euphoria today all the stock markets have done in the past 13 years is grind sideways in a giant trading range!  This has run between 750 and 1500 on the SPX, with occasional forays beyond these secular support and resistance lines like the one we’ve seen so far this year.  The SPX has barely advanced because we are in a secular bear. Like it or not, that is fact. 

Secular bears are the second halves of the third-of-a-century Long Valuation Waves.  The reason stocks merely consolidate throughout their 17-year durations is because of valuations…. Throughout secular bears, valuations gradually fall as corporate earnings rise on balance while stock prices don’t advance on balance.  The result is the valuation downtrend highlighted above by the large blue dotted arrow.  Even at today’s much-celebrated nominal record highs, which are far from records when adjusted for inflation, the SPX is only up 6.9% absolute over a long 13.1-year secular-bear span.

Secular bears exist solely to drag valuations down from bubble extremes when secular bulls end to deeply-out-of-favor cheap levels when these secular bears end.  Just as secular bulls end at valuations exceeding twice fair value, secular bears end at valuations under half fair value.  Until we see 7x earnings, today’s secular bear isn’t over yet.

In March 2000 when this secular bear was stealthily born, the SPX’s P/E ratio was far above bubble territory at 43.2x earnings!  It fell sharply during this secular bear’s first cyclical bear.  Realize that secular bears are punctuated by a series of cyclical bears which cut stock prices in half followed by cyclical bulls doubling them again.  The result is the secular bear’s sideways grind within a giant secular trading range.

In October 2002 when this secular bear’s first cyclical bear bottomed near SPX 750 secular support, the SPX was trading near 25.8x earnings on an MCWA basis.  Thus much progress had been made in valuations.  After being cut in half in that cyclical bear, the SPX would double again over the subsequent 5 years or so in the next cyclical bull but, even as stocks rallied, corporate earnings were climbing faster.

So between October 2002 and October 2007 when the SPX was up 101.5% in a typical mid-secular-bear cyclical bull, its P/E ratio fell to 21.3x earnings.  Despite stocks being more than twice as high and above their SPX 1500 secular resistance, they were cheaper just as you’d expect in a secular bear but cheaper doesn’t mean cheap.  If I try to sell you a hamburger for $50 and then discount it to $35, it still isn’t cheap.

21x earnings, one-and-a-half times fair value, has been expensive all throughout US stock-market history and that is exactly where the SPX is trading today!  If you buy a company trading at 21x, and its profits don’t grow, it would take 21 years just for that stock to earn back the price you paid for it.  That’s a long time for us mere mortals who really only have four good decades to invest (from 25 to 65 years old).

After that last cyclical bull peaked in October 2007, a cyclical bear began that would ultimately cascade into a once-in-a-century stock panic.  It more than cut the SPX in half, pummeling it temporarily below its 750 support.  By late February 2009, the SPX was trading at just 11.6x earnings.  This is well below fair value and approaching classically cheap but it was still 2/3rds higher than the secular-bear-ending 7x!

The last secular bear ended in August 1982 at a broad-market valuation of just 6.6x earnings.  That sideways grind lasted 16.5 years, right in line with the 17-year secular-bear average.  If our current secular bear is over as the bulls believe, then it had to have ended in March 2009.  But could a secular bear give up its ghost less than 9 years in when it was nowhere close to classically cheap?  History argues no way.

Out of those deeply-oversold stock-panic lows a new cyclical bull within this secular bear was born.  It has been powering higher ever since, the SPX up an astounding 141.3% (well beyond the customary double) in 4.2 years.  Yet earnings have merely kept pace with the rising stock prices, as evidenced by the relatively flat P/E ratio lines of recent years.  So today the SPX is once again trading at 21.0x earnings.

This valuation is way above this secular bear’s valuation downtrend, which would have the stock markets under fair value by now (13.1 years into a 17-year event).  21x is still expensive in an absolute sense, and it happens to be the exact same valuation the last cyclical bull topped at in October 2007!  So when the bulls parade on CNBC and claim stocks are cheap today, they are either lying, misleading, or naive.

Stocks are actually just as expensive now as they were right as the last cyclical bear within this secular bear was born.  This next chart zooms into the span that encompasses both toppings.  If 21x earnings wasn’t cheap enough to stave off the last cyclical bear, why should 21x earnings be cheap enough to short-circuit the next one?  Relatively, 21x is far more expensive now much deeper into this secular bear.

October 2007 felt a lot like today, greed, euphoria, and complacency reigning supreme after a mighty cyclical bull had brought stock prices back a little above breakeven from the March 2000 secular-bull top.  Investors felt great with nary a fear in the world.  They hadn’t seen a stock selloff for so long that they were convinced stocks would rally forever.  We had entered a brave new era devoid of downside risk.

The SPX was trading near 21.3x earnings then in MCWA terms and 23.1x in simple terms.  Then, like now, Wall Street analysts aggressively argued that stocks were cheap.  Then, like now, they abandoned using firm trailing P/E ratios to venture out into the fantasyland of estimates.  They talked in terms of forward P/Es guessing future earnings and silly adjusted P/Es ignoring any inconvenient expenses.

If there’s one thing everyone should have learned in the last 13 years, it’s that all the wishful thinking and bullish arguments in the world can’t derail a secular bear.  Secular bears exist to drag stocks sideways long enough for earnings to grow dramatically enough to force valuations from above 28x to under 7x.  Until that 7x metric is seen late in the 17-year span, only fools assume a secular bear is over. Indeed, from those supposedly-cheap levels in October 2007, the SPX plummeted 56.8% over the subsequent 1.4 years in a brutal cyclical bear climaxing in an ultra-rare stock panic.  While I certainly don’t expect another stock panic in my lifetime since it takes generations to lay the necessary sentiment foundation for one, another cyclical bear is certainly overdue.  Secular bears don’t end until stocks are cheap absolutely.

Today the SPX is well above secular-bear resistance of 1500 after an exceptionally long and exceptionally large mid-secular-bear cyclical bull.  These beasts have an average lifespan under 35 months with a target of doubling.  Our current specimen has been blasting higher for over 50 months now, with an astounding 141.3% gain.  It is too old and too large to survive much longer….As of the end of last month, the SPX was trading at 21.0x earnings in MCWA terms and 22.8x in simple-average terms!  This is nearly identical to the 21.3x and 23.1x seen surrounding that last major topping.  Stocks are definitely not cheap.

If 21x was too expensive earlier in this secular bear to keep an overextended cyclical bull from topping, why wouldn’t 21x be too expensive today?  Remember fair value is just 14x, and secular bears don’t end until valuations get near half that at 7x. 

The bottom line is that, despite bulls’ assertions otherwise, the stock markets are not cheap today.  They are quite expensive and very overbought, ripe for a serious selloff. The S&P 500 stock index now has average valuations matching the ones seen in October 2007 when the last cyclical bull topped. Valuations should be around 12x or 13x now, 13 years into this 17-year secular bear.  To get from 21x to 13x would require the broad stock markets to fall on the order of 38%!  I don’t expect this to happen rapidly, as cyclical bears within secular bears generally take a couple years to unfold but I do know nothing can resist secular bears.

(Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.)

*http://silverdoctors.com/adam-hamilton-spx-topping-valuations/#more-26413 (Their Original Source; written by Adam Hamilton, CPA; copyright 2000 – 2013 Zeal Research (www.ZealLLC.com); for tactical trading details subscribe to our Zeal Intelligence service; visit www.zealllc.com/adam.htm for more information on how to direct questions to Adam; direct your thoughts, comments, or flames to zelotes@zealllc.com.)

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