Reality Check: Is Market Detached From Its Fundamentals?

Oct.23.12 | About: SPDR S&P (SPY)

From March 6, 2009's intraday low to September 14, 2012's intraday high, the S&P 500 (NYSEARCA:SPY) has returned an incredible 121%. Yet, many traders and investors have missed much of the amazing rally. There are a lot of reasons why this has happened. But I think the two most important factors are: (1) the ongoing Eurozone crisis and political dramas around the world that constantly drive the risk-on and risk-off cycles, and (2) widespread valuation concerns that the market is sugar high and detached from fundamentals.

Here I'm looking into the valuation issue and trying to specifically answer the question: has the market performance detached from the underlying fundamentals? I will first examine the correlation of the S&P 500 index with a few key economic indicators. Then I will follow it with a historical look of the S&P 500's EPS and P/E ratio. At the end, I will reach a conclusion.

Market Correlation With Real Retail Sales

The following figure from FRED (Federal Reserve Economic Data) shows how closely the S&P 500 index has correlated with real retail sales (including food services) since 2007.

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Below is the same correlation since 1992. You can see that over the long term (last twenty years), the S&P 500 index does seem to track real retail sales. Since 1992, the only period of significant deviation was the late nineties when the high tech boom drove the market to bubble proportion. As for the current bull market, there's simply no similar detachment of market valuation well above the real retail sales growth trend.

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Market Correlation With Real Personal Income

The following figure shows how the S&P 500 has correlated with real personal income since 2007.

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Below is the same correlation since 1990. Again there is no evidence the market currently has moved well beyond its longer-term (22 years) correlation trend with real personal income.

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Market Correlation With Employment

The following figure shows the correlation of the S&P 500 index with total nonfarm payroll employment since 1990. The S&P 500 index did grow faster than the nonfarm payrolls lately. But as you will see below, it tracks better with the decrease rate of initial jobless claims.

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The following is the S&P 500 index plotted against the (negative of) 4-week moving average of initial claims since 2007. You must have seen similar graphs somewhere, since Business Insider has published this correlation in the past. Joe Weisenthal has used this correlation to prove that "the market is based on economic fundamentals." Well said.

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But I do want to caution you ahead that, even if the economy continues to improve, one day the initial claims will stop decreasing (say at 300K), thus making it appear that the stock prices are beginning to detach from the initial claims.

Market Correlation With Industrial Production

The following shows the correlation between the S&P 500 index and industrial production since 1990.

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Market Correlation With ISM Non-manufacturing Composite Index

According to Bloomberg, non-manufacturing makes up almost 90% of the U.S. economy. So it is important to see how the S&P 500 index correlates with ISM non-manufacturing composite index (NMFCI). The following shows such a correlation since 2008 (the entire period the NMFCI data are available from the FRED database). Again the correlation looks quite good overall.

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To sum it up, we have examined the correlation of the S&P 500 index with several key economic indicators, including real retail sales, real personal income, nonfarm payroll, initial jobless claims, industrial production, and the ISM non-manufacturing composite index. As a whole, the S&P 500 index has not shown significant detachment from its historical trend-correlation.

S&P 500 Correlation With Earnings Per Share

I know what you are saying now. The economic indicators impact corporate America's earnings power. But only earnings are the real fundamentals and drivers for the S&P 500 index. Bingo. You have just hit the core of the issue. I really wish those talking heads and strategists who keep on complaining about market's detachment from fundamentals are as clearheaded as you are.

(All the plots in this section were based on data published by S&P.)

The following chart plots the S&P 500 index (quarterly closing price, green line with scale on the right) alongside reported quarterly operating earnings per share (blue line, scale on left) from Q1 1988 through Q2 of 2012. On the left of the plot, it appears that the S&P 500 index was playing a catch up of the robust operating EPS that lasted until 1997. On the right, since the start of 2010, the S&P 500 appeared to be actually lagging the EPS growth. If there is any detachment to the fundamentals, it appears to be a discount or distrust among the market players obviously due to the jittery about European crisis, dysfunctional Washington politics, and lately the weakening emerging and global economy.

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A more intuitive way to view this correlation is of course by simply charting the P/E ratio over the years. Below is a plot of the P/E (E being the operating EPS) ttm from Q4 1988 through Q2 2012. As you can see, contrary to the belief that the current market is frothy, the S&P 500 was trading at almost the lowest valuation in the 24 or so years. During this long span of history, before Q3 2011 there were only four quarters that had a P/E as low as or lower than Q2 2012. They were Q3 1990 and Q4 1988 through Q2 1989.

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I understand that some of you prefer the reported EPS instead of the operating EPS. I can tell you that, other than the absolute value, the result is pretty much the same. The following plots the S&P 500 P/E ttm from Q4 1988 through Q2 2012. Again, it is obvious that the S&P 500 P/E values since 2010 were among the lowest in the past 24 years.

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Conclusion

By examining the performance of the S&P 500 index versus various key economic indicators and its real fundamentals, the P/E, for the past two decades or more, there is no evidence that the market is frothy or detached from fundamentals, like many strategists have constantly claimed. On the contrary, compared to its historical P/E ratio over the past 24 years (which is almost a quarter century), it appears that the S&P 500 is undervalued or the most attractive during this whole period. The stock market can tank from here for a lot of reasons, but frothy fundamentals are certainly not one of them. As a trader, you can sell or short the market during various periods, but don't get caught up doing that for the wrong reason.

Disclosure: I am long AAPL, XPO, FRC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.