As 2015 is firmly over, investors are contemplating what 2016 might bring. The market volatility of the last few months seems to have left many investors nervous.
When markets are volatile many analysts come out of the woodwork to predict an impending crash. Likewise, when the markets are doing well there is no shortage of bullish sentiment. In the financial world people build careers on making big predictions about the market. When they are right, they scream it from the rooftops, but when they are wrong they sweep it under the rug.
The investing industry is fraught with people who act as if they know it all. However, the investing industry is based on making predictions about the future, which is arguably an inherently foolish task. Even the best make many mistakes, and not admitting that their forecast might be wrong is foolish at best and intellectually dishonest at worst
My aim with this article is therefore not to predict when and how much the market will crash. But one thing is certain, bull markets always end and I believe that we are coming to the end of the current one. 2016 will be a tough year because valuations look stretched, and if we have a crash there’s a big risk it will be worse than 2008.
Is It All Coming To An End?
The average bull market in the US after the Second World War lasted for 50 months. The current bull market has now lasted for around 81.
There are signs that the market has topped out already. It has been volatile in the last few months and is struggling to reach new highs, which can be seen from the chart below. When we look at the chart it becomes quite obvious that it doesn’t look normal. The bull market since 2009 has been quite extraordinary, and we can’t expect a trend like that to continue to infinity. A run like this is historically followed by a crash.
But we can’t just look at a chart and conclude that stocks are overvalued. If it were only that simple. Moreover, it doesn’t give us any indication about timing. We therefore have to dig a bit deeper and what we find is that although the market seems to be doing alright (notwithstanding recent volatility), there are a few companies that are pulling up the performance, while the majority of companies are lagging.
The S&P 500 is an index that is often used as the proxy for the US market. It contains 500 companies and is weighted by company size (bigger companies get higher weightings in the index).
Currently companies such as Google, Amazon and Facebook, which are among the ten biggest companies in the index, are pulling up the general market. However, if the S&P 500 was equally weighted (every company in the index would have the same weighting) the results would look different.
The chart below shows the price of the S&P 500 in comparison to a theoretical index that is equally weighted.
This index paints a different picture to what we are used to seeing, one in which stocks are actually down year on year. A market that is propped up by the performance of a few stocks is generally not seen as a healthy market, but again it’s not enough to conclude that a crash is around the corner.
We therefore move on to comparing the stock market to the bond market. Most retail investors don’t follow the bond market, which is a shame because it can often give clues about the economy and the stock market.
The chart below shows the S&P 500 compared to bond spreads (junk bonds vs. treasuries). The green line falling signifies that investors are requiring a higher return when lending to risky companies, compared to when they are lending to the government.
When the economy is doing well and investors are confident, they are willing to take on more risk (lending at lower rates), but when the spread increases it means they are nervous about the market (lend at higher rates because they are afraid of defaults).
Since the summer of 2014 yields have been increasing (green line falling), while the stock market has been rising. This might signal that the bond market is getting nervous, but that the stock market has not caught on yet. This same trend occurred in the summer of 2007, before the market topped in October of 2007 and then crashed in 2008.
Valuations At Elevated Levels
There are currently several valuation metrics that indicate the market is overvalued, however this is a topic of great disagreement in the industry. Bears will argue that the market is stretched and about to crash, while bulls have found a way to adjust these metrics so they don’t look overvalued. You must understand that both camps have a vested interest, and their opinions are naturally biased.
A popular measure that indicates that stocks are overvalued is a ratio that is popularly called the “Buffett Valuation Indicator”, which looks at stock valuations to total GDP. In a Fortune magazine article in 2001 Buffett said that
“it’s probably the best single measure of where valuations stand at any given moment”
It’s not necessarily a good stock market timing tool, but it’s good for indicating whether stocks are expensive or cheap.
The ratio is substantially above where it was prior to the financial crisis, but still some way off where it was in 2000. The message is clear though, which is that stocks look expensive.
Another valuation measure that is helpful for indicating over- or undervaluation is the Q ratio. It measures total stock market value compared to the replacement costs of all the companies in the market. This metric tells a similar story as the “Buffett Valuation Indicator”; the market looks expensive.
People are quick to criticise this ratio, and several of their arguments make sense.
They say that over the last 20 years the Q ratio has only dropped below its long term mean twice, and during those two instances they only dropped slightly below and stayed there for a very short time. Investors who used the Q ratio to wait for a more reasonably priced market would have missed out on the entire bull market that started in 2009, and they would likely have stayed out of the market for the last 20 years, which arguably would have been a bad decision.
However, we’re not using this measure to time the market, nor to predict how far the ratio will swing to either side. We are using it to get a sense of whether the market is under or overvalued. No matter how much skeptics criticise the ratio, it’s difficult to argue that the market is not expensive and I certainly don’t believe one can argue that it’s cheap.
The last measures we will look at are the market’s median price to earnings ratio and median price to sales ratio. These are both overstretched compared to the 2000 and 2007 market tops.
We should especially find the price to sales ratio intriguing because while many may argue that earnings can be manipulated (affecting the price earnings ratio), sales are more difficult to goose. Moreover, the chart shows median earnings, so it is not skewed by outliers on either side of the spectrum.
The message seems to be quite clear, markets are expensive.
Markets are ever evolving and things change with the potential of more stimulus being a key driver. Perhaps the US economy is as strong as many people would have us believe (but that’s a topic for a whole other article) and there may be a big chance that the Fed could reverse its decision on raising rates and even introduce quantitative easing 4 (QE 4). The big question mark for me is whether we will have a crash first, then more stimulus, or if the central bankers will pull the trigger as soon as the market wobbles.
The aim of this article was not to predict when, or how, much the market will crash, there’s enough of that material out there already. The aim was to give a view of how the current situation actually looks and to show people that we find ourselves in a precarious situation.
The stock market appears overstretched and running out of steam, with 2016 having the potential to an ugly year. If there is a crash, there’s a big chance it will be a nasty one. There are of course situations that may change this hypothesis. As investors we tend to be set in our ways because we don’t like it when people challenge our views. But we need to be open to other opinions; if not it can be damaging to our portfolios.
But remember, it’s natural for stock markets to crash and they eventually recover. And it’s at the depths of a crisis that opportunity presents itself because we can buy stocks cheap when everyone else is panicking.