Yes Virginia, this is a real volcano and TINA and VIX are no dependable hiking guides.
Valuations are notorious poor timing tools, but they sure are good at warning of impending danger.
From my December 7, 2017 post THE TAAL EQUITY MARKETS:
Equity investing also remains very imprecise in spite of all the attention and dollars involved. The main volcano is thoroughly analysed and pretty well understood. But the lack of volatility provides a false sense of safety which is drawing in the crowds, right when danger is rising underneath. The less visible volcanoes add to the risks as their eruptions can set up a violent chain reaction.
The prehistoric and historic record of equity markets provide ample evidence of overvaluation and high probability of meaningful corrections. The current “volcanic products” are not of a benign character as this volcano is filled with debt and speculation, highly flammable material with rising interest rates and inflation.
- Equity, bonds and high yield market valuations are just as excessive, if not more than in 2008.
- Complacency and bullishness are as high as in 2008.
- Overall indebtedness is as high, if not higher than in 2008.
- The Fed has turned clearly more hawkish and the ECB will likely soon become less accommodative.
It is thus wiser to keep a certain distance, making sure every investment is made with an appropriate margin of safety.
As I write this Tuesday morning, the S&P 500 is set to open near 2600, 9.3% below its January 26 peak of 2866.
On trailing EPS of $132.74:
- The trailing P/E is 19.6. Downside to the median since 1927, 1953 and 1983 of 13.7 is 30%. To the median since 1993 of 18.5: 5.6%.
- The Rule of 20 P/E is 21.4. Downside to “Fair Value” of 20 is 7.1% (2415).
The new U.S. tax bill immediately increases corporate profitability by some 6%. If we pro forma earnings and boost trailing EPS to $140.70 the trailing P/E declines to 18.5 and the Rule of 20 P/E to 20.3 (2560 on the S&P 500) (chart below).
Markets generally overshoot.
The 200-day moving average is 2531 and it is still rising.
At 2500, the S&P 500 would be at 17.8x P/E and the Rule of 20 would decline below fair value at 19.6. At its low in 2016, the Rule of 20 P/E was 18.3 (2325) but earnings were falling then while they are rising strongly this year. At its lows between 2014 and 2015 (rising earnings and stable inflation), the Rule of 20 P/E did not drop below 19.0 (2415).
That said, sentiment is a very fickle thing and things can get worse. The Rule of 20 P/E dropped to 17.1 in 1994 and 2006. That would be 2150 at current pro forma trailing EPS and inflation (1.8%).
Using pro forma EPS after Q1’18 we get these readings:
- current P/E at 2600: 18.2
- current Rule of 20 P/E at 2600: 20.0
- Downside to 19.0 on Rule of 20: 2465
- Downside to 17.1 on Rule of 20 P/E: 2200.
So worst case is another 15% decline, a true bear market. Seems low probability at this point without high recession odds.
Most likely case: 2400-2500. A good correction to around the 200-d. m.a..
Lowry’s Research says Monday was the second consecutive 90% Down Day. I will come back to that tomorrow.
