There have been a lot of articles in the media in recent weeks concerning whether the stock market is over-valued or "very expensive" and may be approaching a peak. One highly regarded researcher is Robert Schiller, who in August of 2014 was interviewed by many media outlets concerning the high level of the CAPE Ratio (cyclically adjusted P/E) to give his views. Using this analytical approach he notes, "The United States stock market looks very expensive right now."
I take a slightly different approach to look at the relative value of stocks compared to historical norms, but reach the same conclusion as Dr. Schiller. The analysis, as summarized in the graph below, simply looks at the ratio of the traded value of the DOW relative to the nominal GDP (stated in billions) during the same time period. Most recently the U.S. nominal GDP was just over $17.3 Trillion, and the DOW was trading at 17,098 at the end of August giving a ratio of .98.
The ratio is functionally useful in highlighting periods when the market is in outlier territory. Presently, the stock market indices (NYSEARCA:DIA) (NYSEARCA:SPY) (NASDAQ:QQQ) by relative measure are expensive. However, history has demonstrated stocks can trade at these levels for extended periods before a steep correction occurs. Since the 1990s, expensive in relative terms is a necessary but not sufficient reason for a major decline. Saying stocks are expensive is different from trying to assess whether they are at a peak, and a portfolio adjustment toward higher liquidity and lower risk is a good play.
What is the likelihood that the S&P500 at 2000 is a peak?
To make a reasonable assessment of this question, I do not know an accurate one statistic tells all model. I suggest you must get a broad perspective of the most important factors that drive the flow of funds into investments, and assess the relative balance of major market forces to make a market peak assessment. For this purpose, I have developed a heuristic model which follows four major forces in the market to make the assessment - Fed Policy, U.S. Fiscal Policy, GDP Growth Sustainability and Energy Market Price Volatility. The remainder of this article assesses these four important forces at the end of August 2014 relative to their position in the market peaks of August 2000 and August 2007.
Fed Vows to Continue ZIRP - Despite QE Taper
Fed policy continues to be aggressively accommodative going into year-end 2014, even as it is projecting a wind down of the massive $1.54T QE program begun in January of 2013.
The easiest way to see the market rate impact of the Fed's QE program and ZIRP (zero interest rate) policy is to review the current Treasury yield curve. (NYSEARCA:TLT) (NYSEARCA:TLH) (NYSEARCA:SHY) (NYSEARCA:IEF) (NYSEARCA:TBT) (NYSEARCA:IEI) (NYSEARCA:LQD) As the above graph shows, the current yield curve is suppressed below historical norms and remains upward sloping. The market crisis level accommodative policy is still being utilized seven years after the mortgage market crisis.
When reviewed in comparison to year 2000 and 2007, you can see the stark difference in the FED policy in 2014. In both 2000 and 2007, the yield curve was flat and inverted in many maturity differentials, as can be seen in the negative 10/2 and 10/5 spreads and positive 10/30 spread in the following table.
The exceptionally low interest rate policy for U.S. Treasuries is currently projected to continue into the end of President Obama's administration. How this can be accomplished without additional QE is a minor mystery to me, but we do know that international money markets are aiding in the on-going demand for Treasuries, even while U.S. investors continue to hold a lower and lower proportions of the publicly traded float of U.S. Treasuries. In fact, U.S. based owners have been net sellers of Treasuries over the past year, most likely plowing more money into equities while the Fed buying program and continued international purchases soak up the excess inventory.
The announcement of a new QE program being initiated by the ECB on September 4th most likely will continue to drive the flow of funds into the U.S. Treasury market from overseas.
Until the yield curve flattens substantially, as it did in 2000 and 2007, the stock market is likely to remain at expensive price levels. A below inflation Treasury interest rate environment yields no place to hide for U.S. money managers unless fear rises substantially in the market. The one scenario I foresee producing a major market breakdown without the typical flat yield curve is the dreaded deflationary market spiral which the "world awash in liquidity" policy is being implemented to avoid.
You have to go back into the late 1940's for examples of stock market corrections during an extended ZIRP environment and deflationary market pressures being prominent. In the late 1940 early 1950 market peak scenarios, the FED did not use the Fed Funds rate to tighten credit markets causing an inversion of the yield curve. Instead, the entire Treasury curve would flatten, while business credit spreads would widen relative to Treasuries. Under the current FED monetary policy, you should not expect a pure yield curve inversion to signal a market peak; but I do expect to see a flattening of the Treasury curve (narrowing of the 10 / 5 Spread) and a widening of spreads between Treasuries and riskier credit (see BAA1 / 30 Year Spread). Presently, the Treasury curve is flattening, but the business credit market has not yet shown a clear deterioration warning signal.
Lending Activity Heats Up to Warning Zones
One aspect of the recent U.S. economic growth that is not widely recognized is that it is being fueled by renewed high levels of debt being taken on by consumers, businesses and investors. It is debt levels that most often derail GDP growth, and it certainly was evident prior to the last two market peaks.
If you review the statistics show in the table below, you will see that just like 2000 and 2007, debt levels in 2014 have risen to warning zone levels on a relative basis (red = historically high, yellow = approaching historical high levels).
The most unsettling statistic is the renewal of the long-term trend in which consumers are taking on an ever greater share of debt to replace lost income which fuels GDP over the short term, but eventually leads to a sharp downturn economically because it is not sustainable. This trend dates back to the early 1990s when consumer credit outstanding measured in the 12% of GDP range versus 18.57% today.
The Fed ZIRP policy encourages the continuation of low interest rate lending activity and the perpetual refinancing of debt. In spite of increased strictness in underwriting regulations, the financial system continues to show an increasingly burdened consumer carrying a disproportionate share of the load, while on the whole U.S. consumers have shrinking income levels to amortize the debt.
One bit of positive news for bulls, when loan delinquencies across the various debt sectors are reviewed, currently the trends show continued improvement in 2014. In 2000 and 2007 the delinquency low points had been set and a reversal was beginning in the sectors most vulnerable in the ensuing decline. You can see this visually in the graph below:
Comparison Show Mortgage Market Still Recovering
Overall mortgage debt has finally shown a stoppage of the downturn in mortgage balances (deleveraging that occurred mostly through foreclosures and fire sales) that began in mid 2008. Mortgage debt outstanding peaked in 2008 at $14.8T, and relative to the U.S. GDP was over 100% in magnitude. The mortgage market is very large, and ensuing declines after the crisis have been a major drag on the economy. Mortgage lending presently continues to trend lower as a share of the economy relative to 2007, but still has a long way to go to get back to the levels in place in the 1990s. Mortgage loan delinquencies are also trending lower, but remain historically high.
Look for Weak Links as the Fed Policy Changes
The current excessive liquidity in the financial system is very likely covering up weak links as loans are rolled over and re-financed in the hope that the future will change. Weak loans will eventually be exposed in a tightening Fed environment. Because it is an indicator that can be masked until the trouble is beyond repair, if the market becomes fixated on a particular market segment like it did with the bankruptcies in the telecom and internet sector (remember Enron, MCI and others) in the year 2000 and the mortgage sector in 2008, this would be a time to be very concerned about your equity positions.
Presently there is scant evidence of market concern in this area, like Janet Yellen's recent testimony concerning the high yield business loan market which essentially was ignored by the market a week later. This time around I suspect the ticking time bomb will be in the business lending market. One canary in the coal mine might be defaults in the energy boom sector, which for reasons elaborated on below, could reverse a trend that presently appears to be a false positive tailwind to economic growth. I suggest heightened alert as the Fed begins to tighten.
Fiscal Policy a Headwind versus Previous Stock Market Peaks
U.S. fiscal policy is an economic headwind without any apparent current political movement to change. The policy is a counter inflationary force foremost, but secondarily potentially slows down economic growth. You can see the evidence that the present fiscal policy is currently tight by reviewing the August 2014 year over year fiscal expenditure growth rate compared to previous years when the stock market peaked.
This data is surprising to many people, because they are so accustomed to hearing how Washington is out of control from a spending standpoint. The data, however, is actually pointing in a different direction presently, and back-up the Fed Chair Yellen's continued comments that lack of fiscal policy support is making the Fed's job more difficult.
A longer historical perspective of the growth rate in government spending is useful in providing a relative perspective on the current fiscal expenditure growth of the Federal government. This data is important because the Federal government is presently spending over $3.9T a year (22.7% of GDP).
How can President Obama, the leader of the "tax and spend" party, somehow be in charge of the tightest fiscal budget in terms of growth rate since Harry S Truman in 1946 through 1948? The data since 2010 show this is true. But recall that his first budget was in 2009. During that budget, the Congress increased spending by almost $1T a year on a permanent basis, from about $2.8T to $3.8T; thereafter, rather than growing expenditures, the newly established elevated levels have been maintained with only minor yearly increases. The money flowed in many different directions, and you can decide for yourself the effectiveness of the programs which were and probably still are being funded.
If the 2009 government spending level increases had continued, in all likelihood the Fed QE program introduced in 2013 would have been a major inflationary disaster. On what basis do I make this assessment? If you review the data in 2011 (about 18 months into the implementation of the Obama spending program), inflation growth (3%+)and M2 monetary growth (10%+) were on the cusp of taking off to historical high levels, just like the 1970s. The fiscal policy restraint put in place in 2011 appears to have stop this trend before it got out of control, and may have reversed it to deflationary levels.
Historically, correlation data analysis shows that easy, not tight fiscal expenditure growth combined with easy monetary policy is highly correlated with inflation. QE by itself does not highly correlate with CPI-inflation; but rather is more prone to cause equity price increases and financial instability.
The upcoming 2014 mid-term elections will most likely reinforce the current budget constraints; and in a static view of current trends I expect that the market will continue to expect low inflation as a result. However, threats to this view are present which I expect to destabilize the current status quo. These include a possible need for increased military spending to deal with the uprisings in Iraq and Syria, and the known projected increases in entitlement programs which will begin to really ramp up in 2016. When data begins to reflect fiscal spending growth returning to historical norms, I expect the exposed excess market liquidity position created by the Federal Reserve will heighten the need to raise interest rates very quickly, exposing overextended investment positions in the process.
U.S. Energy Market Providing Economic Tailwind - For Now…
In 10 out of 11 major market downturns since 1950, either oil market price spikes or supply disruptions have been closely associated with the event. The sudden price change dynamics in the oil market in 2000 and 2007 as the stock market was peaking are very evident in the graph below. What does the market show today about the probability of an oil price shock? (NYSEARCA:OIL) (NYSEARCA:USO) (NYSEARCA:SCO) (NYSEARCA:UCO)
In my on-going analysis of the energy market, I foresee a low probability for rapid price increases in the U.S. in the next year. This view is based on the characteristic upfront surge in supply from new hydraulic fractured wells which is keeping strong downward pressure on U.S. price levels for both oil and gas. This phenomenon is a blessing, but also a potential curse.
In the short term, I expect the relative ease in energy price levels to be a tailwind for economic growth in the U.S. However, the economics of "fracking" at low price levels is a sucker investment bet, and I fully expect that excess capital in the sector is going to run and hide soon. (See recent articles such as Halcon's Wilson Drills More Debt Than Oil in Shale Bet, Dream of U.S. energy independence was just revised away)
The interim impact of lower U.S. imported oil needs is that oil dependent countries for foreign exchange are losers in the international relative balance. Oddly, accompanying the short-term much stronger marginal position for the U.S. in the energy market is an on-going process of monetary debasement by the Federal Reserve. History shows that conflict surges when actions to debase the U.S. currency are taken to the detriment of energy resource rich countries. In the current act of this on-going saga, there is a triumvirate of the U.S., Europe and Japan central banks all using the same race for the ugliest currency playbook while the price of energy is being capped on a relative basis. Given the current supply windfall in the U.S., it is hard to see an immediate threat of an oil price spike - the bellwether that has accompanied all of the recessions since the Arab Oil Embargo in 1974. However, an international supply disruption is not out of the realm of possibilities given the conflict in the Ukraine as well as the recent surge in terrorism and territorial advances lead by ISIS.
A supply disruption directly affecting international markets, and in particular Europe in the coming winter if the west and Russia do not resolve their differences, is a growing likelihood. Such an event would qualify as a "black swan" which the market is not prepared for in my opinion. If a supply disruption were to occur, I expect the U.S. equity market to initially project a "subprime" is contained response (while the smart money bails-out). Just as the economic recession in 1957 post the Suez Canal blockage incident in July 1956 showed, the U.S. is not immune from these events.
Bull Market Needs More Force to Knock it Down
When the current all-time high stock market values are evaluated relative to four key market forces, Fed Policy, Fiscal Policy, GDP growth sustainability and Geo-Political Risk, the likelihood the market is setting a peak presently is moderately high, but not yet at warning levels. However, I think the risk is growing rather than decreasing based on the direction the relative forces are likely to move in the next year.
Here is the basis on which I currently draw this conclusion:
- Stocks are expensive, but have been at these levels in the past for extended periods before declining.
- Fed policy remains aggressively accommodative even with QE expected to end before year end. An inverted yield curve which typically foretells a steep market drop is not on the immediate horizon and there is still room for credit spreads to move to more typical warning levels.
- U.S. fiscal policy is currently a non-inflationary force, unique in the post WWII era. Until the current low growth rate in Federal expenditures changes, interest rates will remain low, supportive of current "expensive" market valuations.
- Recent increased U.S. economic activity has been accompanied by relative debt levels returning to warning levels reached in prior market peaks in consumer, business and margin loan segments, with the exception of mortgage debt. However, at present the delinquency rates on the loan segments which are growing fastest are not indicative of pending economic strife, as was the case in the peak of 2000 in sectors such as telecom and just becoming visible in the mortgage sector in 2007.
- The chance of an energy sector oil price spike in the immediate future is considered a remote possibility in the U.S. market. However, the risk of an international supply disruption which could indirectly drive down the economy on a delayed basis is an elevated potential threat. An oil price spike or supply disruption is the one closely associated event almost always present as the stock market peaks.
Given this analysis, maintaining equity positions but not extending further seems a prudent course going into the end of the year. Additionally, letting more portfolio revenue bleed to cash, as well as building a stronger cash base by selling low quality equity positions at high relative prices is also where I think investors should be focused.
If you are concerned about unexpected market events like international energy supply disruptions, buying some put options on a major market index while the VIX (VIX) is showing low implied volatility is a possible way to keep your positions in tact while awaiting the impact of what I expect to be a Fed and Fiscal policy shift going into 2015.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.