The Value of Nothing

The S&P 500 closing last week at a brand new all-time high means there is no shortage of “gurus,” bloggers, and media types calling for anything from a pullback to an outright crash in U.S. equities. The rationales that get attached to these claims never cease to amaze me. This time, the primary catalyst being blamed for the anticipated downdraft is “valuation.” This calamity story is another reminder of why it’s critical to be data dependent and process driven in financial markets.

Let me be clear that I’m not one of the many perma-bull U.S. equity cheerleaders who believes it’s always a good time to invest in the S&P. Rather, I’m perma-agnostic, and I let the data and my gravitational framework tell me when it’s time to be bullish, bearish, or completely out of a given market.

For instance, I carried a bearish bias on the S&P from August 2015 to September 2016 after carrying a LONG or NEUTRAL bias for 138 of the prior 141 weeks.

I’ve been LONG the S&P 500 since last September, and right now both the data and the framework are saying there is only one way to continue to trade the S&P: from the LONG side.

True Value

If there is one thing people love to chirp about, it’s valuation, and there has been no shortage of bandwidth used to tout how overvalued U.S. stocks are right now.

The problem with this valuation argument is that stock markets don’t correct or experience significant drawdowns because of valuation. People don’t wake up one morning and suddenly decide that 26x earnings is too much to pay for the S&P 500.

Here I pause to make a request to Buffett disciples who make the pilgrimage to Omaha every year to kiss the ring, and spend their weekends sifting through company balance sheets looking for the diamond in the rough: please keep nasty emails and passive-aggressive tweets to yourself.

I’m not implying that valuation as a metric isn’t useful as part of certain investing strategies. What I am saying is that using valuation as a metric to decide when the stock market is ready for a correction is like using the Super Bowl to determine the future direction of the stock market.

Back in the 1970’s, Leonard Koppett figured out that the Super Bowl winner could accurately predict the future direction of the S&P 500.

If the AFC team won, the S&P would lose ground over the next 12 months, but if the NFC team won, then the S&P would gain in the following year.

At the time Koppett discovered this “connection,” the Super Bowl had accurately predicted the S&P direction 100% of the time. As of last year, this predictor of S&P returns has been right 40 out of 50 years — an 80% success rate!

Clearly, the Super Bowl has no real connection to the S&P 500; this is just a coincidence. In a similar way, stock market valuation has no real connection to causing corrections.

Shiller Says What?

A lot of valuation practitioners like to quote the Shiller P/E Ratio when they talk about markets being “overvalued.” I like numbers and being data dependent because numbers have a way of cutting through narrative and clarifying.

Over the past 40 years, the average Shiller P/E ratio has been 21.6. For the sake of our evaluation, let’s assume that a Shiller Ratio reading that is 1 standard deviation above the 40-year average is “overvalued” and any reading 1 standard deviation below the average is “undervalued.” Here’s how the data stacks up:

Overvalued Market:

Average monthly return = +0.83%

Percentage of positive months = 58%

Worst monthly return = -14.6%

Average losing month = -3.9%

 

Undervalued Market:

Average monthly return +0.82%

Percentage of positive months = 56%

Worst monthly return = -22.0%

Average losing month = -3.6%

The statistics for the two different valuation regimes are very similar, which highlights the problem with using valuation as a stock market catalyst. The notable difference is that the “worst monthly return” was nearly double when the market was “undervalued.”

Even if valuation has some impact on the direction of the S&P 500, it’s minimal to say the least. Not to mention that historic returns indicate that investors should prefer an overvalued market to one that is undervalued.

The $64,000 question is this: if valuation isn’t a catalyst, then what is?

There are three critical forces, or gravities, that impact asset prices, and all three are decidedly bullish for the S&P right now.

It’s FUN-damental

The most important factors influencing asset prices are the trajectory of economic growth and inflation, and how central banks respond to those conditions.

The fundamental gravity for the S&P 500 has been bullish since midway through Q3 2016 when economic growth started to accelerate higher. The early data in 2017 shows that the acceleration is continuing into the new year. Labor data to start the year has been strong, and reports from both manufacturing and service sectors are showing continued strength.

From a policy perspective, the Fed normalizing rates won’t on its own cause a correction. The higher the interest rate differential between the U.S. and the rest of the world, the more it encourages assets to flow to all U.S. markets, equities included.

U.S. politics will have their influence, as well. Even if Trump isn’t able to push through his entire agenda just as he wants, the majority of his policies are pro-growth, which in turn will be pro-U.S. equities in the short term.

The Math

Our quantitative gravity, which is made up of multiple factors over multiple durations, is also tilted heavily bullish.

Two of the main quantitative factors, volume and volatility, are both indicating that there is further upside to the S&P’s post-election move.

Volume is expanding on up days and declining on down days, which is a classic bull signal.

People are talking negatively about the extremely low level of U.S. equity volatility. However, when volatility falls as a market rallies, it’s a very bullish sign. And the reality is that this muted volatility isn’t widespread. There are a number of markets experiencing increased volatility, but the S&P 500 isn’t one of them. That’s because it’s one of the most attractive markets for investors who need to put money to work on the LONG side.

The current reading for the S&P’s quantitative gravity indicates that it could rise to the $2,367 level before becoming overbought. This means that the S&P could rally another 3% before I’d be concerned about a pullback.

Our framework also helps us to anticipate what price action to expect once this gravity reaches an extremely bullish reading. In the S&P’s case, once an extremely bullish quantitative signal registers, it leads to a pullback of 2% over the following 10 trading days. Once that pullback is complete, the S&P rallies 5-9% over the next three months.

Humanness

Despite the fact the S&P has jackknifed since the election, gaining 10% and closing at an all-time high last week, the behavioral gravity remains bullish.

In a word, people aren’t yet bullish enough on the S&P 500. Like our other gravities, our behavioral gravity is multi-factor and evaluates metrics like positioning in the S&P futures market as well as the fund flows for ETFs. These measures of investor behavior are providing further evidence that being LONG the S&P is not yet a consensus idea.

In fact, speculators in the futures market could add another 40% to their LONG exposure, or approximately another $22B, before I would be concerned that LONG positioning was reaching an extreme level.

The Bottom Line

Trading based on “valuation” or the latest story being woven by the media is the quickest way to find yourself ordering from the $1 menu at a fast food joint while feverishly attacking your lotto scratchers hoping your “investment” hits pay dirt.

I’ll stay bullish on U.S. equities until the data and the gravitational framework tell me otherwise. That shift in bias could come next week, next month, or next quarter. But until that shift comes, I’ll be trading the S&P from the LONG side whenever the market offers me a price that skews the reward-to-risk balance in my favor.

Stay data dependent, process driven and risk conscious, my friends.