This page has been archived and commenting is disabled.

A Reversion to the Mean is Coming...

Phoenix Capital Research's picture




 

The stock market is no longer cheap.

 

The single best predictor of stock market performance is the cyclically adjusted price-to-earnings ratio or CAPE ratio. Most investors price a company based on its current Price to Earnings or P/E ratio. Essentially what you’re doing is comparing the price of the company today to its ability to produce earnings (cash).

 

However, corporate earnings are heavily influenced by the business cycle.

 

Typically the US experiences a boom and bust once every ten years or so. As such, companies will naturally have higher P/E’s at some points and lower P/E’s at other. This is based solely on the business cycle and nothing else.

 

CAPE adjusts for this by measuring the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation. By doing this, it presents you with a clearer, more objective picture of a company’s ability to produce cash in any economic environment.

 

We have mentioned before that CAPE is the single most important metric for long-term investors. I wasn’t saying that for impact.

 

Based on a study completed Vanguard, CAPE was the single best metric for measuring future stock returns. Indeed, CAPE outperformed

 

1.     P/E ratios

2.     Government Debt/ GDP

3.     Dividend yield

4.     The Fed Model,

 

…and many other metrics used by investors to predict market value.

 

So what is CAPE telling us today?

 

The S&P 500 is currently at a CAPE of over 26.

 

 

The S&P 500 has only been at this level or higher a handful of times in the last 100 years. All of them have coincided with major market peaks.

 

This is not to say that the market will crash tomorrow. However, there are considerable signs that the market is in trouble.

 

Those of you who have been reading us for some time know that we prefer to use nominal GDP as a measurement of GDP growth in the US.

 

The reason for this is that all “adjusted” GDP data involves a “deflator” metric that is meant to adjust for inflation. The Feds often use an inflation adjustment that is even lower than their official Consumer Price Index metric (which is already massaged to downplay inflation) in order to make GDP growth look greater.

 

Consider this simple example. Let’s say that the US GDP grew by 10% last year. Now let’s say that inflation also grew by 10%. In this scenario, real inflation adjusted GDP growth was ZERO. However, announcing ZERO GDP growth is a major problem politically. So what do the Feds do? They claim that inflation was just 8%, and BOOM you’ve got 2% GDP growth announced for a year in which real GDP growth was actually zero.

 

By using nominal GDP measures, you remove the Feds’ phony deflator metric. With that in mind, consider the year over year change in nominal GDP that has occurred.

 

 

As you can see, we’ve broken below four, the reading that has been triggered at every recession in the last 30 years.

 

The primary drivers of asset prices are the economy and corporate earnings. The above chart shows that the US is on the brink of a recession. With that in mind, consider that corporate profits are at all time highs.

 

Not only that, but corporate profits, as a percentage of GDP are at all-time highs. Never before in history have corporations made so much money relative to the US economy. This trend is not likely to continue.

 

 

So, we have a weak economy, record profits (mostly from cutting payroll by firing people) and record profits as a percentage of GDP. The simplest interpretation of this is that there will be a reversion to the mean at some point.

 

So… we’ve got:

 

1)   Stocks overpriced based on the most predictive metric out there (the CAPE).

2)   The US economy at or near recession territory.

3)   Corporate profits at record highs.

4)   Corporate profits as a percentage of GDP at record highs.

 

The market is primed to drop. Now is the time to prepare.

 

If you’ve yet to take action to prepare for the second round of the financial crisis, we offer a FREE investment report Financial Crisis "Round Two" Survival Guide that outlines easy, simple to follow strategies you can use to not only protect your portfolio from a market downturn, but actually produce profits.

 

You can pick up a FREE copy at:

 

http://www.phoenixcapitalmarketing.com/roundtwo.html

 

 

Best Regards

 

Graham Summers

 

Phoenix Capital Research

 

 

- advertisements -

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Thu, 10/09/2014 - 14:56 | 5309965 pupton
pupton's picture

It looks as if this stopped clock (Graham) is about to be right, finally....

Thu, 10/09/2014 - 13:26 | 5309370 kindape
kindape's picture

will we revert all the way back to the mean when you started saying we would revert back to the mean? (2009)

(I generally agree w you Graham, but calling wolf for so many years leaves one w little capital vs the mob)

Thu, 10/09/2014 - 15:01 | 5309991 pupton
pupton's picture

Precisely!  Graham has been saying the sky is falling for as long as I have been reading ZH (over three years.)  He hasn't been right yet.  I hope he's not betting other people's money on his theories.  Even a stoped clock is right twice a day, and Grahams day may be coming, but does he deserve the credit if/when it does? 

It is almost like Peter Schiff, whom I respect, calling for things for years that aren't happening.

Sure, we can blame the fed or whatever, but at some point we have to say "look calling a top for 5 years and declaring victory in year 6 when it happens doesn't make you a guru, or even average."

Thu, 10/09/2014 - 11:34 | 5308810 SuperRay
SuperRay's picture

How about the right side of a head and shoulder pattern being formed right now. Gives us about a month

Thu, 10/09/2014 - 11:30 | 5308759 Spungo
Spungo's picture

Reversion to the mean: when you realize that beautiful woman you slept with was an outlier, and the rest of your life will involve fat women with big feet.

Thu, 10/09/2014 - 10:54 | 5308591 SAT 800
SAT 800's picture

What's he want to preapare for ? Why not just short the bitch and go fishing?

Thu, 10/09/2014 - 11:04 | 5308668 AdvancingTime
AdvancingTime's picture

Only problem in this false rigged market they have been kicking in the teeth of bears for years as they blow out stops.

 

The question is, how high is high? Picking the top has proven to be a bitch. I plan to hold the line, the day of reckoning will come.

Thu, 10/09/2014 - 10:53 | 5308578 AdvancingTime
AdvancingTime's picture

The Fed minutes yesterday confirmed concern about the pressure a stronger dollar is putting on other currencies around the world. Bottom-line is other currencies are under assault because both economies are weak and countries are buried in debt they can never repay. This adds a great deal of validity to an article I recently penned concerning what may be a major shift in the markets.

For months the major world currencies have traded in a narrow range as if held in limbo by some great force. This has allowed people to think we were on sound footing as central banks across the world continued to print and pump out money chasing the "ever elusive growth" that always appears to be just around the corner. Recently some currencies have made multi-year highs or lows depending on the match-up .

Because of weak demand for goods and most of this money flowing into intangible investments inflation has not been a major problem, but the seeds for its future growth have been planted everywhere. John Maynard Keynes said By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

While there are not many Bond Vigilantes there are a slew of  Currency Vigilantes and they are ready to make their presence known. Weakness in the value of the Yen, Pound, and Euro must not go unnoticed. More on why this may be a signal that currency trading is about to get very wild in the article below. Please note, this may also be sending a signal that the whole system is unstable and the stock market is about to drop like a stone.

http://brucewilds.blogspot.com/2014/09/caution-alert-currencies-may-get-wild.html

Thu, 10/09/2014 - 10:47 | 5308564 no more banksters
Thu, 10/09/2014 - 10:42 | 5308527 I Write Code
I Write Code's picture

 

corporate profits, as a percentage of GDP are at all-time highs.

Well, that can be because of the numerator, or the denominator.  Or both.  If profits stay the same but the non-corporate economy tanks, that percentage goes up anyway.  Profit margins are high because of cheap borrowing, and stocks are high because of share buy-backs.  Now, when ZIRP ends and corps pay back all that cheap money profits will fall too (though balance sheets will look better not worse!).

IOW, when QE and ZIRP end of *course* there will be some reversion to the mean.  But if they manage to keep most of ZIRP even without QE, it may be years unfolding that, so that reversion may be spread over two years, or five, or ten.  I'm sure that is the plan.  At such a slow rate, it is meant to be swamped by real growth or even mere inflationary growth.

Do NOT follow this link or you will be banned from the site!