Further Evidence of an Overvalued Market

By Lance Roberts, CEO, StreetTalk Advisors

Today’s chart of the day was the result of a question by my friend Richard Rosso who asked if corporate profits were suggesting that the current market environment was becoming overvalued.  The timing of the question was apropos as I was already pondering a statement made by Matthew O’Brien at the Atlantic who stated:

“Just because the price of something is going up doesn’t mean it’s a bubble. Even if it’s going up a lot. And even if it’s something you don’t like. After all, there might be a good reason it’s going up so much. A good reason like … record profits.”

While Matthew was addressing whether, or not, the artificially inflated markets have once again started to reach “bubble” territory, and there are certainly arguments that suggest it well could be, the importance of his argument really focuses around the notion of record profits.

The mistake that is likely being made by many is the assumption that when profits reach a new “record” it is the beginning of a new trend rather than the end of something that begin some time ago.  The issue comes when mainstream analysts begin manipulating data in order to justify current market dynamics.  In this instance in order to justify high market prices one must assume that the current “record” levels of profits will continue forward indefinitely.  The problem with that assumption is that this has never been the case historically and one that will likely not manifest in the future.

The chart below shows several things of importance relating to the current valuation of the financial markets.  The only valid measure of market valuation that is historically consistent is trailing twelve month REPORTED earnings per share.  Using other measures such as operating, or pro-forma, earnings to try and justify current market levels is both inconsistent and inaccurate when performing valuation analysis.  I have also included price to corporate profits (NIPA) per share for a comparative measure.

-earnings-profits-pershare-trend-082813-3

 

 

As you will notice each time that corporate profits (CP/S) and earnings per share (EPS) were above their respective long term historical growth trends the financial markets have run into complications.  The bottom two graphs shows the percentage deviations above and below the long term growth trends.

What is important to understand is that, despite rhetoric to the contrary, “record” earnings or profits are generally fleeting in nature.  It is at these divergences from the long term growth trends where true buying and selling opportunities exist.

Are we currently in another asset “bubble?”  The answer is something that we will only know for sure in hindsight.  However, from a fundamental standpoint, with valuations and profitability on a per share basis well above long term trends it certainly does not suggest that market returns going forward will continue to be as robust as those seen from the recessionary lows.

John Hussman recently summed this up well stating:

“The period of generally rich valuations since the late-1990’s (associated with overall market returns hardly better than Treasury bill returns since then) has created a tolerance for valuations that, in fact, have led to awful declines, and have required fresh recoveries to elevated valuations simply to provide meager peak-to-peak returns. At the same time, the intervening recoveries to the 2007 highs and again to the recent market highs, coupled with what Galbraith called “extreme brevity of the financial memory” have periodically convinced investors that the market will advance diagonally forever. History teaches a different and very coherent set of lessons:

  1. Depressed valuations are rewarded over the long-term;
  2. Rich valuations produce disappointment over the long-term;
  3. Favorable trend-following measures and market internals tend to be rewarded over the shorter-term, but generally only while overvalued, overbought, over bullish syndromes are absent;
  4. Market losses generally emerge from overvalued, overbought, over bullish syndromes, on average, but sometimes with ‘unpleasant skew’ where weeks or even months of persistent marginal advances are wiped out in a handful of sessions. The losses often become deep once the support of market internals is lost. When a broken speculative peak is joined by a weakening economy, the losses can become disastrous.”

While there may not be an asset bubble currently; valuations by both of the metrics (CP/S and EPS) studied here are clearly rich.  However, for investors, it is important to remember that valuation measures are horrible short term market timing devices.  In the long run valuations mean everything.  While I am not suggesting that the market is about to plunge into its 3rd major reversion for this century, even though that possiblity does exist, I am suggesting that future returns will likely not be anything to write home about either.

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Lance Roberts

Lance Roberts

Lance Roberts is the CEO of STA Wealth Managment. The mission of STA Wealth Managment is simple - lead our clients to financial success by actively managing their assets while limiting risk to capture returns. Through the utilization of economic and technical analysis, historical research, and risk controls, we build portfolios which will create long-term investment results.

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