Today I start with a US stock market indicator that’s been flashing warning signs.
It might be a red herring. But with American equity indices at extremely extended valuation levels – as I explain lower down – it could be signalling the top.
The Hindenburg Omen is named after the German airship that came to a tragic end in a devastating explosion 80 years ago. The ‘Omen’ is a technical indicator that tracks the number of stocks trading at 52-week highs relative to those on 52-week lows. And it sometimes acts as a harbinger for a stock market crash.
America’s S&P 500 index drives equity benchmarks around the world. In early-August, US equity indices hit another all-time high. But they’ve since eased, with more stocks hitting 52-week lows than 52-week highs in a way that hasn’t been seen since July 2015, according to Sundial Capital Research president Jason Goepfert.
What’s more, the divergence triggered a Hindenburg Omen marker on the S&P 500 in five recent sessions. “It is a serious signal that highlights times of decoupling within an index or exchange,” notes Goepfert. “The S&P hasn’t suffered five signals so tightly clustered since 2007, and 2000 prior to that.”
In November 2007, according to MarketWatch, US stocks fell by 1.6% in the week following the signal and by 2.3% two weeks after that. A year later, the S&P 500 had plunged lower to the tune of 40%.
This year, across all four main US indices, Goepfert has counted 74 omens so far, second only to 78 recorded in November 2007. “In 2000, it only got up to 57 and in May 2015, it got up to 54. Both led to poor returns for late buyers as the indexes finally gave up and followed lagging sectors lower,” he says.
Now I don’t usually set too much store by technical indicators alone. There often seems to be a reason why the past doesn’t replicate itself as many such gauges suggest that it should.
But these aren’t exactly normal times. For example, as I illustrated here, interest rates are at 5,000-year lows.
And on the measure that I’m looking at today, the S&P 500 index is at its most expensive level ever.
Compared to potential economic growth, earnings multiples on the S&P 500 – using a variation of the Shiller P/E, the Hussman P/E and the Peak PEG ratio – even top those seen during the 2000 tech bubble, says Francisco Filia of Fasanara Capital.
Whoa! Jargon overload. What does this mean in plain english?
Nobel Prize-winning economist Professor Robert Shiller developed the Shiller P/E, otherwise known as the cyclically-adjusted P/E or CAPE, which compares the last 10 years’ average corporate earnings against the current price. The Shiller P/E is now at 30x. It’s only been as high as, or higher than, this level twice before, in 1929 and in 2000. And we know what happened on those occasions.
The Hussman P/E has been calculated by fund manager John Hussman (whose work I’ve followed for years as it’s been one of the few sane voices in the ongoing market madness). Hussman adjusts the P/E Shiller by using peak rather than average earnings. On his barometer, the S&P 500 is pricier than in 1929 though it’s still less expensive than it was in 2000.
Now for the price/earnings to growth (PEG) ratio: this divides the P/E by earnings growth. In other words it compares current valuation against growth potential. The Peak PEG ratio factors in peak earnings over the last 10 years and adjusts them for long-run GDP growth. On this measure, US shares have never before been so costly. In fact, they’re 60% above their historic average fair value.
“The only metric left out there, where they look less expensive, is when compared to bonds: government bonds, corporate bonds and now also junk bonds”, says Filia. “Except that bonds themselves are in a bubble after $14 trillions of them got soaked up the last 10 years by major central banks globally, now owning over 30% of total outstanding. Only the Bond Bubble can justify the Equity Bubble – a drunk who drives home another drunk.”
Now the S&P 500 might not seem quite so overvalued if US corporate earnings are about to take off. And if you believe consensus analyst forecasts, you might be persuaded that the market isn’t quite as expensive as it currently appears.
In fact, the last quarter’s reported earnings figure for the S&P 500 index was actually no higher than the same period in 2014 and only just over a third higher than 2006 (since when the index has almost doubled!) Yet despite the history, analysts are predicting a reported earnings surge over the next 12 months of some 30%.
Is that remotely likely at this stage of the economic cycle? The so-called recovery since the great financial crisis has been based on massive debt increases plus huge debt monetisation. These can’t continue. Indeed, the trends need to be reversed. But despite the surge in global borrowing, GDP growth is still sluggish. And while the exact timings remain unclear, the US Fed is still broadly in interest-rate hike mode.
Further, as Lance Roberts at Real Investment Advice notes, analysts are notorious for being much too bullish initially, then slicing their earnings estimates as time goes on.
Looking at the upside potential/downside risk balance for US equities, I consider there’s much more chance of a major index pullback than another surge in share prices. This would have a major adverse impact on the FTSE 100, along with other mainstream market indices worldwide.
This time, the warning from the Hindenburg Omen might prove to be right.