Equity Valuations And Monetary Measures Say Time To Go Back To Harbour

Summary

• Key monetary measures now signal the U.S. bull market is at or near its peak.
• Meanwhile, stock market valuations are at euphoric highs strongly suggesting the risk of a major correction outweighs any upside potential.
• The U.S. stock market really is in unchartered territory this time, not due to extreme valuations alone.
• Investors should therefore contemplate going back to harbour to figure things out and return when valuations and downside risks are lower.

The stock market moves in cycles. Over the longer term fundamentals rule, of which the money supply play a more central role than many realize as it affects nominal corporate sales and profits (which are of course stated in money terms).

Over the shorter term investor appetite play a more prevalent role. This becomes noticeable near market tops when greed drive prices above what any reasonable assessment of fundamentals would suggest and during market crashes when fear dominates and fundamentals for a while become largely irrelevant.

Today, ten years on from the previous bull market peak, it is more challenging than any time during this entire upswing to find a sufficient amount of sound explanations as to why U.S. stock market valuations should be anywhere near the current extraordinary highs.

With one exception of course; the ultra low level of interest rates. That is to say, it is largely low interest rates alone and the speculation they motivate that now drive Wall Street to ever new highs though they cannot become much lower.

But any investor hanging his hat on this one factor is assuming an extraordinary level of downside risk and bleak prospects for positive returns.

Just like an apple in the air must drop to the ground, an inflated asset must at some stage deflate - it is perhaps the nearest modern-day economics will ever come to physics. This is more true today than arguably at any stage during this entire bull market as even the money supply impulse has now become an adversary, as opposed to an avid supporter, of further stock market gains.

In fact, the money supply growth rate is now the lowest it has been during the entire period since the 2008 U.S. banking crisis.

Meanwhile, money supply volatility has been increasing rapidly all year, a development which often culminates with decreased financial stability.

Watching the stock market rally further under such circumstances surely is a sobering experience. Mister market is always right. But the market is also right when stocks crash, is it not?

There is really no such thing as a definite value of a stock. Value is always subjective - it is in the eye of the buyer and seller whose preferences are prone to change, at times rather quickly and without much notice. Valuations are the results of definite action which is either to buy or not to buy from the perspective of the buyer or to sell or not to sell from the perspective of the seller. There is however such a thing as appraisal - a solemn attempt to judge the possible future value of an asset based on fundamentals. As Percy L. Greaves, Jr once put it,

Appraisal or appraisement is an impersonal judgment, often by a disinterested expert, of the price something would bring if sold in the market place."

The problem involved in appraising a financial asset is of course why Benjamin Graham speaks of a range of possible values. But the appraisal process is fraught with assumptions and theories that may prove incorrect, especially over the shorter- to medium term as investor psychology (e.g. P/E ratio) can change faster than fundamentals (e.g. earnings). For example, based on the economic developments and stock market price movements during the last ten years I can tell you there is a 100 % chance the U.S. stock market will crash. But I cannot tell you exactly when.

Extraordinary results in the world of stock market investments are not about perfect timing - far from it, but about managing probabilities successfully over the longer term. That is my view anyway. And, as the charts below indicate, probabilities do not seem to favour the bull at this stage. Have a glance and judge for yourself.

Chart 1: The Wilshire US Mid-Cap Total Market Index to M2 Money Supply Ratio

Chart 2: The Wilshire 4500 Total Market Index to Commercial Banks' Equity Ratio

Chart 3: Wilshire 5000 Total Market Full Cap Index compared to 7-year rolling average and monthly Manufacturing Shipments

Chart 4: Russell 3000 Total Market Cap Index to four-quarter rolling average Gross Private Domestic Saving

Chart 5: Wilshire 5000 Total Market Full Cap Index to Retailers Sales Ratio

Chart 6: Wilshire 4500 Total Market Index to Disposable Personal Income

Chart 7: Weekly Stock Market Valuation Indicator

Chart 8: Monthly Stock Market Risk Indicator Stocks may of course move higher still, but you would bear an exuberant level of risk betting large on it. The U.S. stock market really is in uncharted territory this time. Not because of extreme valuations alone, but as they today combine with a tremendous amount of government- and private debt, the low level of saving that has defined the U.S. economy for decades (here), and interest rates which can head few other places but up (and some already are, e.g. Fed funds rate and LIBOR).

Though an increased quantity of money drives stock market prices, it is production and saving that drive economic growth. Without the latter, which is the situation today, the former will have a tendency, absent QE, to deflate. This is already taking place as the above money supply chart and table above show. Bar some miracle, the combination of high valuations, slowing money supply growth, and a historic high level of quantity of money relative to saving (chart above) simply cannot end well.

I'll leave you with some words of wisdom from a trader (who appeared to have more common sense than student debt) named Stan Jonas who played a part in the BBC movie about the demise of LTCM nearly 20 years ago:

When do you admit that you're wrong, start all over again. Or when do you hang on and assume that the markets will turn around in your way. That's the biggest decision we all have to make. However, there is one thing that is clear. Over the last several hundred years we've been able to identify some people that can do it better than others. They don't necessarily go to MIT, they don't necessarily have degrees in mathematics so that doesn't automatically rule them out. They are the kind of people that can make that judgement that says something's different here, I'm going back to harbour until I figure it out. Those are the kind of people you want running your money.

Disclosure: I am/we are short MYY. 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.