Valuation and Sentiment Roundup

Valuation

It’s been approximately 3 months since we last looked at valuation indicators in the US and abroad.  Now that equity markets have rallied extensively around the world over the past quarter, it’s a good time to revisit some of the valuation metrics.  For good measure, we’ve also included several sentiment indicators that might provide some extra color in terms of trying to figure out if the rally has more upside from here.  

First, let’s focus on US valuation metrics.  As in the past, we’ll focus on two primary valuation indicators in the US: the Shiller 10-year CAPE normalized P/E, which uses Professor Robert Shiller’s public earnings database and takes average trailing 10-year earnings as a way to eliminate some of the volatility in the S&P 500 earnings number; and, the Q-ratio, which uses US government data to approximate a real-time price to book ratio for US equity markets.  Both of these indicators have displayed reasonable statistical significance in terms of predicting future 10-year annualized returns.

The Shiller P/E for the US is 22.6x as of today, which is approximately 1 standard deviation above the long term average P/E of 17.4x.  At this level, predicted annual returns for the S&P 500 over the next ten years (including dividends) come in at 2.5% adjusting for inflation (real return) and 6% nominal, versus long-term averages of 5.73% and 8.88% respectively.  In other words, this long-term P/E metric predicts sub-average annual returns for the US over coming years.  

The Q-ratio for the US is currently 0.97 versus a long-term average of 0.74.  This is approximately 0.8 standard deviations above the average.  Currently the Q-ratio predicts long-term, annual, total real returns of 2.6%, almost exactly in line with the Shiller P/E number provided above.  The charts for both indicators follow.  As you can see, current US valuation levels are still far from levels typically associated with secular bear market bottoms.  Significant progress has been made; the starting levels for these valuation metrics at the beginning of the secular bear market in 2000, however, were astronomical relative to historical experience.

Source: IronHorse Capital, Federal Reserve Bank of St. Louis, Bloomberg

Source: Shiller Online Data, IronHorse Capital

Moving on to global markets, we’ll use Jim O’Neill’s normalized earnings data from Goldman Sachs below.

Source: Datastream and GSAM calculations as of February 2013, Goldman Sachs

 While his US calculation deviates slightly from ours (actually more elevated), the point to take away from the global perspective is that US markets are among the most over-valued when compared to the peer group.  Conversely, long-term valuations for nearly all global Developed and Emerging Market equity indices remain decently below their historical averages.  Among the major global indices, only Australia and Mexico join the US in trading above historical mean.  Even with recent rallies, many European markets remain significantly undervalued.  The highest valued major European market is Germany, and it’s still just middle of the pack.  Amazingly, both the IBEX index in Spain and the FTSE MIB Index in Italy are up over 30% since last summer, yet both indices still trade at single-digit valuation levels.  Emerging markets ex-Mexico show decent under-valuation.  Granted, growth metrics have been spotty of late in Brazil and Russia, but these two emerging market anchors are trading at valuations below most if not all of the developed world.

Market Sentiment

Traders and investors often eye various market sentiment indicators for clues as to whether equity markets are due for a trend reversal.  The metrics are best viewed from a contrarian angle.  Generally, highly optimistic sentiment indicators are associated with market tops, while deep pessimism is associated with market bottoms.  

Many prognosticators of late have expressed skepticism of late about the recent rallies in US and global markets.  Some skepticism is warranted, especially in the US, due to the high valuation levels relative to historical averages.  Interestingly, several indicators that cover equity market sentiment in the US and abroad show lower sentiment levels than many market-watchers would expect at this point in the cycle, perhaps giving some credence to one pundit’s description of this rally as, “The most-hated rally ever.”  On balance, these indicators could show that there’s still decent underlying buying support for this rally over the intermediate term despite the fact that valuations have become elevated.  

In the US, the AAII Bull/Bear/Neutral numbers are widely followed as an indicator of extreme optimism or pessimism.  Currently, the numbers are tilted to the bullish side, but below levels usually associated with major market tops.  To make more sense of the numbers, we use the Farrell Sentiment Indicator developed by Bob Farrell, the former technical strategist at Merrill Lynch.  He devised a formula incorporating the bull, bear, and neutral numbers and takes a 10-week moving average.  If the average pokes above 1.5, the market is far too optimistic.  If the number dips below 0.50, investors are too pessimistic.  Through this week, the 10-week average is sitting just north of 1.0.  As shown in the chart below, sentiment has certainly perked up from summer levels, but remains significantly below levels even a few years ago ahead of the European debt crisis.

Source: Bloomberg, AAII

Another indicator in the US, the put-call ratio, is also showing subdued positive sentiment.  We use the 10-day moving average of the put-call ratio to smooth out any volatility in the underlying numbers.  Currently, the 10-day moving average is 0.96, which is elevated relative to the average of 0.915 observed over the past 10 years.  This is currently approximately 0.4 standard deviations above the norm.  The elevated put activity relative to calls indicated elevated pessimism.  As a point of comparison, the put-call ratio was over 1 standard deviation below normal in early 2011, an indication of extreme optimism and a precursor to the market declines and volatility that occurred later in the year.  It doesn’t appear that investors have thrown caution to the wind yet.  

United States: PUT-Call Ratio: Recent Data

Source: Bloomberg, CBOE

Finally, to capture sentiment in European markets, we’ll refer to the BNP Paribas “Love-Panic” market sentiment indicator.  Again, to smooth out any underlying volatility in the numbers, we use the 4-week moving average.  As of this week, the indicator’s 4-week moving average stands at -0.41, approximately 0.2 standard deviations below the historical average of 4.32.  Like the US, strong rallies of late in European markets haven’t pushed market sentiment to extreme positive levels.

BNP Paribas "Love-Panic" Model, Europe:

Source: Bloomberg, BNP Paribas Equity & Derivative Strategy

Markets in the US and Europe are technically overbought, at least on a short-term basis in many instances.  As such, we wouldn’t be surprised to see some corrective action in coming weeks or months.  The fact that many investors still haven’t joined the market party yet, at least according to sentiment indicators, could help explain recent market action here and overseas where dips are short-lived and decent buying action appears on any pullback.  Accordingly, equity markets could continue to confound and surprise bearish investors in the short to intermediate term.  

Taking the high US valuation figures into account from the beginning of the post, we don’t necessarily believe yet that the US markets have completely exited the secular bear market that began in 2000.  In the US especially, we believe there is more volatility ahead at some point.  Ex-US markets, mainly those in Europe and in emerging markets, remain positioned to outperform US markets over the next decade in our opinion.  Of course, as much as we’d like markets to move in straight lines, there will be plenty of moves and pushes and pulls along the way to keep life in the markets interesting.