Here we go - listen to CNBC, or follow the new twitter hysteria and we have now reached a new dangerously high plateau...
Since election night, the S&P 500 (NYSEARCA:SPY) has staged a 265-points rally fueled by expectations that the New Administration will drive economic expansion and earnings growth. The idea is to attract to the U.S. the production facilities from abroad that serve the domestic market, as well as bring to America foreign-based production facilities that serve non-US markets. It is the so-called "import- substitution-plus" to quote El-Erian's recent words. The unknown is how such a dramatic shift in policy by the country "at the core of the international monetary system" will affect other countries, and the overall global trading system.
We remain skeptical and of the opinion that the broad market is in dangerous territory. The possibility that the New Administration will fail to implement "any" meaningful economic measure is on the rise, with a very real possibility that policy attempts will be countered by both domestic and foreign opposition. The widespread reactions to the Immigration ban of the past weekend are a sound example of what will be the future of policy setting for this Administration.
Earnings since 2013 have stalled with no real growth, while the market continued to push higher, discounting policy effects that still need to be implemented and more importantly bear fruits. Overall, 34% of the companies in the S&P 500 (SPY) have reported earnings to date for the fourth quarter. Of these companies, 65% have reported actual EPS above the mean EPS estimate. This percentage of companies reporting EPS above the mean EPS estimate is below the 1-year (71%) average and below the 5-year (67%) average. In fact, if the index reports earnings growth for Q4 this year, it will mark the first time the index has seen year-over-year growth in earnings for two consecutive quarters since Q4 2014 and Q1 2015.
Valuations are now visibly stretched across the board. Our proprietary models indicate that the market is about 20% overvalued. The comparison of the Rate of Change for both the S&P 500 (SPY) and its earnings shows exactly how the broad market has gone into bubble territory. The market's multiple expansion promoted at the time by Fed intervention through its QE Programs has now, with Trump's election, reached a level that should at least suggest caution. The current Shiller PE is at 28 or 23% higher than its long-term mean. We get the same picture using the forward 12-month P/E ratio for the S&P 500 (SPY) which currently stand at 17.2. This P/E ratio is above the 5-year average (15.1) and above the 10-year average (14.4).
Source: Agon Research LLC
The Fed is also on a path to raise interest rates, which will make the equity risk premium less attractive, leading to an increased pressure on stock valuations and other riskier assets. Higher rates will also lead to reduced stock buybacks, dividends, expansions and mergers, which in the past few years have fueled the market to the tune of some $500 billion per year.
Our base case scenario is two 25 basis points rate hikes this year, in June and December respectively.
Last but not least, while U.S. financial stocks have soared in the post-election euphoria, a massive and broad-based spike in insider-selling (relative to buying) is in the making.
Source: Thomson Reuters
To top it all off, the geopolitical environment is not reassuring. Europe, China, Russia, the Middle East are all question marks in an increasingly uncertain international equilibrium.
Maybe we are just overreacting to a series of material risks. Bulls will certainly argue that the glass is half full, but we are not in their camp. In fact, it is our view is that the market is not discounting the risks highlighted here.
The best advice at this time? "Be Fearful When Others Are Greedy". It is better to sit this one out than be left without a chair when the music stops.
Disclosure: I am/we are short THE S&P500 VIA FUTURES.
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.