How Much Further Can It Go?

Executive Summary

In this week’s issue, three valuation metrics will be shared to illustrate both the current high and the downside of previous market cycles. The Price-to-Sales ratio in the first graph has never been higher. Following in graph two is The Buffet Indicator, take note of the current high as well as what happened after 2000 and 2007. And finally, economist John Hussman’s Nonfinancial market capitalization/Nonfinancial corporate gross-value added presented in the third graph. His indicator is very reliable in correlating with subsequent 12-year market returns. None of this means markets cannot continue higher. What it means is the risk in the market is high and should be considered when investing. Talk to us about our strategies to address these risks. 

For further analysis, continue to read The Details below for more information.

“An investment in knowledge pays the best interest.”
–Benjamin Franklin

The Details

The push higher in the stock market reveals investors’ appetite for risk has not been satiated. Unfortunately, when extremes such as those present today have been reached historically, it always ended in disaster. That is not to say that irrational exuberance will not continue, pushing extremes even further. However, those ignoring the final outcome of every other major bubble, as revealed by history, could suffer consequences like they have never before experienced.

I will show a few of the extremes now setting records. The Price-to-Sales ratio as shown below, from Stanphyl Capital via X, has never been higher.

Warren Buffett’s favorite valuation measure, market cap of publicly traded stocks divided by gross domestic product (GDP) has also reached an all-time peak of 210 according to the graph below from Global Markets Investor via X.

And finally, economist John Hussman’s favorite valuation method (after extensive research) and most correlated with subsequent actual returns, the Nonfinancial market capitalization/Nonfinancial corporate gross-value added including estimates of foreign revenue, is signaling the most overvalued markets in history. This is a variant of a price-to-revenue model and is using data back to 1928. See the graph below from Hussman’s monthly Market Comment.

To show that this methodology is based upon historical data, the following scatter plot shows the subsequent 12-year actual annual return of the S&P 500 (y-axis) based upon the valuation result of the above formula (x-axis). Notice the current reading of 3.46 shows no blue dots around it, because it has never before been that high. However, if historical patterns continue, the current reading should relate to subsequent 12-year returns averaging about -6% per year.

Investors have grown complacent because they are used to the market always bouncing back after minor corrections. Long time investors who have lived through full market cycles, such as the Technology Bubble/Burst and Financial Crisis, realize that the final leg of the cycle has not yet appeared. And when it does, if history is any indicator, years or decades of returns could be erased.

Yes, the bubble can continue longer. But it is critical to understand the environment one is investing…I mean speculating in.

The S&P 500 Index closed at 6,297, up 0.6% for the week. The yield on the 10-year Treasury Note rose to 4.43%. Oil prices fell to $67 per barrel, and the national average price of gasoline according to AAA decreased to $3.14 per gallon.