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I am on record as calling the U.S. stock market a buy in September when Robert Shiller’s PE10 (S&P 500 expressed as a ratio to the average trailing earnings of the past ten years) dropped below 20 and presented value. The PE10 briefly fell to 18.5 on the first trading day of October but the 12.8% rally in the S&P 500 has taken the gauge to 20.7 currently. That compares to the historical average of 16.4 times since 1881 and the low of 13.3 times during the great financial crisis of 2008/2009.

Click on any chart below to enlarge:

Sources: Robert Shiller; Plexus Asset Management.

The rating of the S&P 500 as measured by the earnings yield (inverse of PE10) improved as the anxiety levels in financial markets as measured by the CBOE S&P 500 Volatility Index (or VIX) eased from crisis levels.

Sources: Robert Shiller; Plexus Asset Management.

Anxiety levels remain elevated, though as the VIX is approaching crisis levels again. Since 19 October a significant gap has opened between the PE10 and the VIX where the current level of the VIX is calling for a PE10 of 20.0 compared to the current 20.7. It therefore implies that unless the VIX drops to 28, the S&P 500 could get a haircut of 3%. Please note that the following graph illustrates the daily values I calculate for the PE10 and that the VIX is on a reverse scale.

Sources: Robert Shiller; CBOE; I-Net Bridge; Plexus Asset Management.

In the past I have referred to the relationship between the Conference Board’s Consumer Confidence Index and PE10 as the former is an excellent indicator of the valuation of the U.S. stock market with regard to the state of the underlying economy.

At this stage the PE10 and consumer confidence have parted ways, with the former rising and the latter falling.

Decoupling? No, I do not think so. There are times when consumer confidence leads and times when the PE10 leads. Obviously, when the stock market rallies, consumers are more at ease as they feel wealthier (or less poor) and their confidence improves. What the PE10 is telling me is that the market is probably anticipating a huge rise in consumer confidence to in excess of 60, with the current PE10 one standard deviation above what the historical relationship implies.

The recent surge in stock prices will go a long way to restoring some confidence but I doubt whether 60 is within reach in the short term.

The reason why consumer confidence is so important is the fact that it is a determining factor in the velocity of money in the economy or the rate at which money is exchanged from one transaction to another.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

Currently the level of the Consumer Confidence Index correctly reflects the velocity of money with zero maturity (MZM that includes notes and coins in circulation and cash or near-cash deposits of financial institutions).

Sources: FRED; Dismal Scientist; Plexus Asset Management.

A rise in the Conference Board’s Consumer Confidence Index to 60 implies that MZM velocity should rise to 1.57 from the current 1.46. A jump to 1.57 in MZM velocity would mean the year-on-year growth in GDP (in current money terms) has accelerated by 11% or 7.85% from the third quarter. You will agree that such acceleration is highly unlikely.

Sources: FRED; Dismal Scientist; Plexus Asset Management.

The bond market indicates that we should rather expect MZM velocity closer to 1.40 compared to the current 1.46.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

MZM velocity of 1.57 as suggested by the market via PE10 implies a yield of close to 3% on the 10-year Government Bond Index. Again you will agree with me that this is highly unlikely in the short term.

Sources: FRED; I-Net Bridge; Plexus Asset Management.

Although volatile, the yield on the 10-year note has always been an excellent indicator and anticipator of underlying consumer sentiment.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

The 10-year note is currently priced for the Consumer Confidence Index falling to approximately 30.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

Unemployment plays a major role in consumer confidence. (Please note the reverse scale of the unemployment rate.) Consumer confidence is unlikely to improve significantly unless employment increases drastically.

Sources: I-Net Bridge; Dismal Scientist; Plexus Asset Management.

At this stage of the economic cycle the FOMC would normally be inclined to cut the Fed fund target rate. If the FOMC had not been so dovish in the first half of last year and raised rates even slightly, it would have been in a position to cut the rate earlier this year. Now it has no room to move with the rate hovering around zero.

Sources: FRED; Plexus Asset Management.

It seems to me the FOMC has no alternative but to embark on QE3. There is a flickering of light at the end of the tunnel, though. The 12-month momentum of MZM velocity appears to have bottomed in line with that of the GDP in current money terms.

Sources: FRED; Plexus Asset Management.

The stock market is currently driven by the normalising of anxiety levels, with the S&P 500 Index slightly overpriced by approximately 3% compared to the anxiety levels as represented by the VIX and the PE10. At this stage the current process is resulting in too rich ratings that are out of line compared to the underlying economy as represented by the Conference Board’s Consumer Confidence Index. However, I do think the Consumer Confidence Index is likely to improve close to 50 in the next few months, but not quite to 60 as anticipated by the stock market. The market must therefore be anticipating a big QE3 to justify the ratings!

In sum, I am approaching the U.S. stock market with some caution at this juncture. That said, I remain bearish on U.S. long bonds as I think the U.S. economy is in a somewhat better shape than the bond market is suggesting.

Source: Are U.S. Stock Markets Anticipating Too Much, Too Soon?