Last year's article showed how financial capital flows can be used to provide a valuation model for the S&P 500 (SPY). The Price Channel Indicator calculates a fair price range for the index based on the amount of financial capital previously raised through debt and equity offerings, rather than the more traditional P/E or CAPE ratios. The setting couldn't have been worse. Markets were at frothy levels and you could feel the bearish sentiment in SeekingAlpha articles of the time, such as: Here, here, here, and here.
Because the Price Channel Indicator uses past data to calculate the current price channel, current data offers a forward looking window into future values of the indicator. This is because the act of raising financial capital is not immediately reflected in stock prices, but drives longer term growth (or not, as the case may be).
Below is the chart from the original January, 2017 article. Not only does it indicate that the markets were not over-priced (at least not by this metric), but despite the frothy market levels and negative press, the indicator clearly called for another 9-12 months upward pressure in the market.
Below is the current version of the chart, showing the subsequent surge in the market. I have also included the forward 2-year values for the indicator, which are based on capital which has already been raised. It is important to remember the two-year forward projection is based on historical data. The only thing projected is the dividend yield of the S&P, currently 1.77%. Any changes in the dividend yield will cause only a small shift in future values of the indicator, and do not generally play a large factor.
From this, we can clearly see the indicator will remain relatively flat for the next 2 years. While this may look alarming, extending the chart back to 1996 can lend some perspective to the current situation:
In 1992, the Price Channel Indicator started moving upward at a rapid pace, reflecting a positive imbalance between financial capital and equity prices. This was not immediately reflected in stock prices, which remained under-valued until 1995 and the beginning of the dot-com bull-market. The Price Channel Indicator stayed relatively flat from 1999-2008, and the market surged right through it, dropped 50%, and then doubled again.
Clearly a flat price channel does not mean we should expect a flat market. Historically (see 57 year historical chart at the end of this article) the market tends to become over-valued for 10-20 months before a bear-market sets in. Although this doesn't mean this will continue to be the case in the future, I wouldn't be surprised to see it happen again. While the indicator provides a fair-market value for the S&P, market forces regularly drive it above and below the channel, but usually not by very much.
About the S&P Price Channel Indicator
There are many economic metrics, such as the Fed's Leading Economic Indicator, Gross Domestic Product, Employment, Manufacturing, etc. However, like earnings, these are all based on the output of the economy. In other words, by the time these indicators show a change, the change in the economy has already occurred. We're just measuring it after the fact.
It is more desirable to monitor the inputs to the economy, rather than the outputs. The input to the economy is financial capital, which is raised through equity and debt, and it's spent. People don't get a car loan and then not buy a car. Governments issue bonds for a reason. Likewise, companies that issue new equity spend the money they raise doing so to grow. This is new money that didn't exist or wasn't participating in the economy before the capital was raised.
When you borrow from a bank, they borrow from the Federal Reserve. When you buy into an IPO, you are taking money from your savings or brokerage account (where it wasn't participating in the economy) and giving it to a company to inject into the economy through spending. This provides an impetus for economic growth.
Financial capital is new money entering the economy.
Any other money in the economy was already there.
By tracking the growth of debt and equity liabilities nationwide, we can calculate the amount of financial capital entering the economy. Fortunately, all the necessary data is available from the Fed, who take an active interest in all things related to the economy. We can track the liabilities of companies and households, as well as federal, state, and local governments.
By correlating growth rates in financial capital to the total return of the stock market (approximated by the S&P 500) we can create a price-channel for the S&P 500 that indicates whether stock prices are cheap or expensive with respect to new financial capital that has already entered the economy. This correlates very well historically, as can be seen in the chart below. It bears mentioning the data-points for the red and green lines are known years in advance, yet still correlate subsequent price movement in the stock market.
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.
Additional disclosure: Source: Author's calculations