Economic Cycles – Equity Market Risk – Treasury Yields
June 22, 2017
Figure 1 plots Standard & Poors 500 Index (SPX) and SPX’s index value if it traded at a price-to-earnings ratio (P/E) of 20 (Overvalued), 15 (Fair Value), 10 (Undervalued) and SPX’s aggregate 12-month trailing (12mT) earnings level since 1989. Prior to -50% plus declines begun in March 2000 and October 2007 through February 2002 and 2009 aggregate earnings peaked within 6-months of market Tops. The last 12mT earnings peak was in September 2014 and although we are on track to record earnings of 105.24 soon, that is still short of the 105.96 recorded in September 2014.
SPX closed at 2435.04 on June 21, 2017 with a 12mT P/E of 23.23 and a 120-month average or normalized 12mT P/E of 26.40 (NPE). A NPE near 26 has only been associated with peak earnings in 2007 and 1929 (not shown in Figures 1-2). SPX is not at a reasonable value and although technical readings are neutral and a severe decline is not imminent, market tops usually build over six to nine months. SPX would decline 23%, 42% or 61%, respectively, from its current value to be simply overvalued, fairly valued and undervalued.
Since December 31, 1999, the Arrow Insights Quality Value & Momentum Index (AIQVM) and SPX have performed Good, Better and Best when valuations were more reasonable, the spread between two-year (2Y) and five-year (5Y) Treasury (TSY) bonds were wide and SPX’s volatility index (VIX) was higher (Figure 2). Both indexes suffered badly only when valuations were extreme and the TSY spread was negative (inverted).
InFocus Highlights: (Figures 1-2 end on June 21, 2017)
- Our economic expansion is the second longest on record. A decline of -33% is close to the mean decline had in past recessions (Figure 1). We are overdue for a recession and a bear market.
Figure 1. SPX’s 10Yr Normalized P/Es & Valuation Price Levels
- The mean NPE/VIX Ratio is 1.21 (bottom of Figure 2), which is where NPE/VIX was near at the start of the 2000-2002 bear market. The ratio has only been near 2.5 in 2007 and 2017.
- The TSY spread inverted prior to and during the last two episodes of Federal Reserve rate hikes. Currently, the spread is not inverted but it is narrowing, which is a sign of economic weakness at a time when NPE is extreme and investors are complacent about risk (an extremely low VIX). Over the next two weeks, the InFocus will explore how AIQVM and other Arrow Insight indexes have and might perform in light of the above factors.
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