Market

Insanity!

July 24, 2017

Salient Features of Bull Market Peaks

John P. Hussman, Ph.D.

Last week, the S&P 500 price/revenue ratio reached the highest level in history, outside of the single week of March 24, 2000 that represented the peak of the tech bubble. Meanwhile, the 30-day CBOE volatility index (largely reflecting the level of fear or complacency among option traders) dropped to a record low, as bullish sentiment surged to 57.8% bulls versus 16.7% bears (Investors Intelligence), and the S&P 500 pierced its upper Bollinger bands (two standard deviations above a 20-period moving average) on daily, weekly, and monthly resolutions.

On the measures we find most tightly correlated with actual subsequent market returns across history (see the table in Exhaustion Gaps and the Fear of Missing Out for a comparison of the reliability of numerous alternative measures), the S&P 500 is now between 150% and 170% above valuation norms that have been approached or breached over the completion of every market cycle in history, including the most recent one. Allowing for a lesser retreat ending about 25% above those norms (which is the largest distance ever remaining by the completion of any cycle across history, even those associated with quite low interest rates),

we fully expect the S&P 500 Index to lose between 50-63% as this speculative episode unwinds.

On that note, it’s worth noting that the Shiller CAPE reached 30 last week, which places current valuations among the highest 3% of historical observations, on that particular measure.

In reality, however, the situation is much more extreme.

Put another way, investors are currently paying a very high multiple of a very high earnings number that quietly benefits from cyclically elevated profit margins. 

On the basis of normalized profit margins (an adjustment that improves historical reliability), 

the normalized CAPE would presently 

be 

 40.

While some observers take solace in the fact that the CAPE reached a much higher level of 44 at the 2000 bubble peak, that historical comparison ignores the embedded margin. See, at the 2000 peak, the embedded margin of the CAPE was just 5.1%, compared with a historical norm of 5.4%. At present, because of depressed wages and high profit margins in recent years (which are now reversing given a 4.4% unemployment rate), the CAPE quietly embeds a profit margin of 7.2%.

There is only a single week in history where the normalized CAPE was higher. That was the week of March 24, 2000, when the S&P 500 hit its final bubble peak, at a normalized CAPE of 41.

 DYI: 

At 40 times Shiller PE¹⁰ stocks purchased or held go to sleep like Rip Van Winkle waking 15 years from now the estimated average annual nominal return is….Drum Roll Please….0.68%!  The yield for Vanguard’s Vanguard Intermediate-Term Investment-Grade Fund Investor Shares (VFICX) is 2.60% a clear winner over stocks for the next 15 years no matter which way interest rates zig and zag.

The 10 year holding period stocks are slated to deliver a negative average annual return of….-2.29%!  Suffice to say short, intermediate or long term high grade bonds will out perform stocks over the next 10 years.  So hold onto your hats and your cash better value are ahead!

DYI