December 2013 – Monthly S&P 500 Market Strategy Update

Bubbles, Bubbles everywhere!

Huh?

In my almost thirty years in the financial business – it seems longer – I have been through a few market cycles.  What is inevitable is a chorus of money managers and analysts screaming ‘Bubble’ when equity markets start to recover from cyclical lows.  In most instances the people yelling ‘Bubble’ are the ones who have under-performed the market indices by a wide margin.  ‘Misery loves company’ is a popular idiom that comes to my mind when I see these people interviewed in the business press as bearish equity market strategists and investors love to hang out with each other and share the same echo chamber.  Hopefully by the end of this blog you will be scratching your head along with me when the plethora of ‘Bubble’ interviews and press stories that will be written on the spectacular returns for the S&P 500 for 2013 in the closing months of December and early January 2014.

Another item I would like to get off my chest is this whole subject of ‘Quantitative Easing’ thing.  Market experts have commented that because of ‘Quantitative Easing’ the equity prices are somehow fake or artificially high and cannot be trusted.

Really.

In our highly mathematical world of Model Price Theory (MPT) there is no evidence that I can see that links ‘Quantitative Easing’ to unjustified or artificially high equity prices.  Equity markets in general represent a complex system that can have many influences. Do I think ‘Quantitative Easing’ is a positive in the hundreds of thousands of potential agents acting upon individual equity prices?  Yes I do.  Is ‘Quantitative Easing’ wholly responsible for the levitation of equity prices?  This I cannot agree.

Equity returns over the last 5 years, since the financial crash of 2008, are largely a function of how far the US equity markets crashed in the first place.  I sense market professionals are only looking at the rates of return – that are good BTW – without consideration of where or what valuation level the market crashed in 2008.  As public policy and US Federal government found the right mixture of appropriate policy actions, including ‘Quantitative Easing’, the equity markets have returned to a ‘normal’ valuation level, in my opinion, that is commensurate with the economic activity of the US economy.

How can you call this a ‘normal’ valuation level for the S&P 500?

Listen carefully to these ‘Bubble’ talking heads in the financial press and they start talking price earnings ratios.  Here we are in the 21st century where every industry has been touched by scientific innovation and technological advancements and finance professionals are still using a simple ratio of equity price versus earnings as a guideline to evaluate equity market valuation.

Laughable!

Want a more sophisticated filter to view equity market valuation?  Try Model Price Theory (MPT).

Let’s first look at our super long-term model price chart of the S&P 500.

S&P 500 Index with monthly price bars and EBV Lines (colored lines)

S&P 500 Index with monthly price bars and EBV Lines (colored lines)

Before I detail what our model price chart is communicating let me tell you how it’s constructed.  First, every company in the S&P 500 has a calculated model price chart (data).  We then aggregate all companies by market capitalization, like the S&P 500 Index, on a daily basis. We then construct a time series by amalgamating the daily data over a selected period of time.  We use our calculated constant EBV lines to ensure users can track visually EBV (valuation) levels over time.  The number of calculations to do this is in the hundreds of millions.

A little more robust than the simplistic Price/Earnings ratio, don’t you think?

Observables from our chart

1.  This model price chart goes back to 1995.  Hopefully you can observe the S&P 500 Index is at the same valuation today as we were, some 19 years ago.

2.  From the valuation level of the S&P 500 in 1995, the Index almost reached EBV+6 in the early months of 2000.  (Our calculated EBV+6 for the S&P 500 Index today would be 4448 or 147% higher)

3.  After the tech ‘bubble’ crash of 2000, you can observe where the equity market bottomed in terms of the S&P 500.  Just over EBV+3.  Yes, the market bottomed – approximately – where the S&P 500 is today. (If intellectually honest the market mavens screaming ‘Bubble’ today would have been doing the same during the market lows of 2002, yes?  Probably not.)

4.  From 2002 to July 2007 the S&P 500 Index crawled along EBV+4.

5.  You can observe the waterfall decline in the S&P from July 2007 to March 9, 2009.  The S&P bottomed at EBV+1.

6.  From the market bottom of EBV+1 or March of 2009 the S&P 500 has been working its way upward with a positive transit of both EBV+2 and EBV+3.

A Closer look at our model price chart of the S&P 500

Let’s have a look at our short-term model price chart of the S&P 500

S&P 500 Index with weekly price bars and EBV Lines (colored lines).

S&P 500 Index with weekly price bars and EBV Lines (colored lines).

Observations

1.  Back on the last week of June the S&P touched support or EBV+3 (red line).

2.  From the end of June, the S&P 500 has been working upward through 2nd and 3rd quarter earnings.  Also don’t forget the US Federal government was shut down from October 1st through to the 16th of 2013.

3.  The potential upside for the S&P 500 is EBV+4 or 2029.  This represents a 13% upside from the December 2nd close or 1800.90.

4.  The potential downside, or EBV+3 (red line) is 1622.  Representing a 10% downside, again, from the December 2nd close.

Conclusion

Do you see a ‘Bubble’ in US equities?  I know it’s hard to fathom what the ‘Bubble Heads’ see but I certainly don’t see froth in this US equity market – at least not yet.  Could the market, as defined as the S&P 500, correct to EBV+3 or our red line?  Absolutely.  Would a correction offer investors and traders a great opportunity to purchase US equities?  Again, absolutely!  Will a correction occur?  I don’t know.  Savvy investors are always looking to buy cheaper assets or for model price users equity prices closer to support or their respective EBV lines.  But my gut tells me this US equity market as measured by the S&P 500 is on a roll and momentum can carry this market at least to EBV+4 at which time we can collect our breath and see what this market and individual stocks look like at this EBV level.

See what happens.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s