Yesterday we looked at what happens when the S&P 500 is this far above its long term moving average. If you haven’t yet read that, click on the previous link and read it first because then what follows will make much more sense.
As you’d expect, when the stock market is stretched 20% or more above its 200 day moving average, it has a hard time continuing such a heady move. Instead, we find that the market pauses or retreats in the short term (1 to 3 months). But as Barry pointed out in the comments, there is a difference to how the market behaves in a bear market rally and a real secular bull market. With that in mind let’s analyze the data further.
If you looked at the historical data table that I showed outlining the previous extremes you probably noticed that 4 out of the 13 instances occur very close together in late 1982 and early 1983. This was, of course, the launch pad of the super bull market. The S&P 500 closed at 102.84 on August 10th 1982 and never looked back.
So naturally, there is a cluster of data points (chart below) as the market went on a rampage. This also explains why the 6 month period returns are so inordinately high:
That’s a lot of red marks! Between January 1st, 1980 and June 30th, 1983 there were 28 days when the S&P 500 was above its 200 day moving average by at least 19.5%.
If you look at the chart carefully, you’ll notice something remarkable. Even in such a super-strong bull market, this simple indicator is still able to identify short term tops in the market. But in the intermediate term, the market simply ignored any and all overbought signals. And eventually, by May 1983, they were’nt even able to mark a teeny bit of a correction. After all, in a strong bull market, ‘overbought’ is meaningless.
The question then is, are we about to see something similar? That is, do bull market rules apply? will this most recent extreme be simply the first of many? will the stock market simply ignore each and every one as it goes on yet another rampage the way it did in 1982?
No one knows of course. But personally, I think such a scenario to be highly improbable. It just wouldn’t make sense to expect a repeat of the 1982 experience. For one, we do not have the volume to fuel such a move. Second, and most importantly, we do not have the valuation.
I know, I know, fundamental analysis is for chumps. But I’m not talking about trying to game next quarters earnings estimate. I’m referring to the aggregate valuation of the market. Something for which we have much evidence to indicate excellent predictive value in the long term. For details, I refer you to Shiller’s excellent book: “Irrational Exuberance“.
Let’s pretend to ignore that the market has never rallied 60% in 6 months before. Let’s also ignore that never before has it performed even remotely close to that when the unemployment rate was this high. And ignore that corporate insiders are selling like lemmings. That sentiment is way too optimistic. That 95% of issues closed above their 200 day moving average (and 93% above their 50 day moving average). Even if we brush all of that and more under the rug, we can’t ignore how expensive the market is here:
- the trailing P/E (for operating earnings) is 26
- at the onset of the bear market in October 2007, it was 19
- the trailing Price Earnings ratio is 184 (reported earnings)
- on October 2007 it was merely 23 (in October 1987 it was just 20)
- the price to dividend ratio (click for chart) is at 53
- on October 2007 it was 55 and way back at the start of the super bull (1982) it was 16
- based on one year forward (operating) earnings the P/E ratio is 16 - highest in 5 years
- on October 2007 the forward est P/E was 14 (same as on Oct 1987)
- Price to Book ratio is 2.3 - August 1982 it was below 1 (discount to book)
- based on recent Tobin’s Q analysis, the market is 40% overvalued
While the market is a forward discounting mechanism, there is a limit to how much and how far ahead it can do so. Arguably, at these prices, the stock market is discounting the next 3 years operating earnings (2012). Historically, the market faces strong headwinds when P/E reaches 25. The average 1 year return at that valuation (or higher) is -0.3%. (All valuation data sourced from David Rosenberg’s invaluable research at Gluskin Sheff).
All of the above leads me to conclude that the most apt script is the one we’ve seen before many times in the aftermath of secular bear markets. While the performance of the stock market since March has been more than impressive, the stage is not otherwise set for the launch of a secular bull market.
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