For many months we, and others, have been pointing out that equity valuations have been completely detached from normal fundamentals. This week, we want to revisit the stock market's fundamental footing to see if there has been any improvement, and in addition, we will search the data to gauge the probability of any impending recession.
We start with the price-to-earnings ratio (PE).
As the chart below shows, PE continues to increase and stands at 24.63 times earnings, which is more than 70% above the long-term average of 15. This, of course, is high and shows no improvement during the last quarter.
S&P 500 PE
Next, we look at the price-to-sales ratio, and as the chart below demonstrates, investors are willing to pay $1.89 for every dollar of sales, which is more than at any time in the last 15 years. Again, no improvement here either.
S&P 500 Price to Sales
The price-to-book value ratio is almost at pre-great recession levels. Investors are paying $2.84 for every dollar of company value on the books.
S&P 500 Price to Book Value
The earnings growth rate continues to be negative at -9%. It was worse at the end of 2015, but not by much.
S&P 500 Earnings Growth Rate
None of the fundamentals presented so far, can be used to justify the high equity valuations we see today, but are there any warning signs in the economy that might point to an impending recession that would lead to a stock market collapse?
The percentage of banks tightening their standards on large corporate, and small corporate loans, as well as consumer car loans, tends to rise as the economy works its way toward a recession. The chart below records this tendency going back to 1990.
The chart below shows a closer look at the banks' tightening of standards since the middle of 2015.
Banks tightening their lending standards, implies that delinquencies are on the rise. The chart below shows that this, in fact, is the case. An increase in commercial and industrial loan delinquencies occurred just prior to the previous three recessions.
The next chart shows the total industrial capacity utilization going back three recessions. Just prior to both the 1991, and 2001 recessions, the capacity utilization dropped, stabilized, then dropped into the recession. In 2008, the capacity utilization stabilized near the cycle's high then dropped into the recession. Starting in 2015, the capacity utilization has been dropping, and lately seems to be stable, which fits with the other pre-recession periods.
Looking at real medium household income, we see that it dropped prior to each of the last three recessions (chart below). The latest income figures, however, up to September 2015, show that income has been rising, which does not fit with an impending recession.
Since we do not yet have the data for the latest year, we are reluctant to place too much emphasis on the one sole indicator that isn't pointing to a possible recession, but it is worth noting. In the prior three recessions, household income made a rapid transition from increasing, to decreasing in the year before each recession hit. Since we are missing an entire year's worth of data, we have to consider this indicator as neutral at this point.
In conclusion, most of the fundamental metrics that we looked at, continue in their failure to justify the lofty equity valuations present in the market. In addition, we find that the financial indicators are pointing toward an impending recession, which, if realised, would have a dramatic negative synergistic effect on equity valuations.
Low interest rates are the sole driver of high equity values. As long as funds keep flowing into equities and bonds in search of yield, the high valuations will be maintained. We see the market as increasingly sensitive to the upward bias in rates.
A rate hike has the potential to change the destination of money flows and, therefore, stock and bond values. The CME Group FedWatch Tool is calculating a 70% probability of at least a 0.25% rate hike in December. Nobody is expecting a hike at the November 2 FOMC meeting since this is just prior to the election, but it really would be something if the Fed did raise rates before the election.
If the Fed considers the election as a forgone conclusion, which one hopes it is (for America's sake), then it has no worries about influencing the election and is free to raise rates if the data is there. There is less than a 10% chance of this occurring, per the CME Tool, but we think that this possibility is under-appreciated and has a higher probability than the 8% currently assigned.
A surprise hike would produce a 'perfect storm' of unsupportive fundamentals, weak financials, and rising interest rates, which would have a significant negative consequence on equity values.
We leave you with the chart below that demonstrates the upward bias of all three parts of the Treasury curve, and the inverse relationship between rates and the SPX. Expect the unexpected.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.