Wednesday, November 22, 2017

On a Relative Basis, Stocks are in the Red Zone

The U.S. stock market has rocketed higher since Donald Trump’s election in 2016.  The DJIA (DIA) posted a 28.9% year over year gain through October 31st, and so far in November has shown signs of continuing to move upward.  The rationale behind the market move is simple - stocks are considered a better value than the low interest rate bond alternatives.   

Since the financial crisis in 2008, interest rates have been suppressed for many years now because of Federal Reserve large scale quantitative easing measures, combined with similar bond buying actions by the European Central Bank and Bank of Japan.  The excess liquidity in the market has now inflated stocks to much higher levels.  The question remains, are the present market capitalizations of many companies sustainable?

With the election of Donald Trump, the business news media has become enamored with the idea that economic growth can be pushed much higher in the world as new Tax Reform legislation is passed in the U.S. and interest rates continue to remain historically low.  Therefore, the market commentary goes, stocks are the best investment, and investors need to “fear missing the chance for much higher returns.”

Anytime the market reaches these types of frenzies, it is best to look at relatively similar situations to see if the hype matches reality over a longer time horizon than 3 – 6 months.   As a guide to judge the relative value of stocks and bonds through time, and also to judge whether the market is overpriced, I look at the DOW relative to GDP.  Since 1990 the relative level of the DOW index to the US GDP (nominal) is plotted (gray line) in the graph below:


What you can see from the data is that the DOW:GDP line fluctuates through time, and as the market reaches peak time periods, such as the year 2000 and 2007, the measure approached and exceeded 1.0.  In fact the index was aggressively higher in the late 1990s. 


Just viewing the DOW:GDP relationship in isolation does not provide much information.  The measurement was very low in 1980, and stocks spiked and then corrected.  Fast forward to the late 1990s and stocks spiked higher, and then corrected when the DOW:GDP measurement was much higher.   Today stock investors are faced with the opposite market conditions of the 1980 market, extremely low relative interest rates instead or very high interest rates.  How can an investor tell if stocks are under or overvalued relative to the economy in this diametrically opposite market environment?

Adjusting the DOW:GDP Measure Crucial for Assessing Relative Value

 

There are two additional market elements which must be considered by investors to judge whether the DOW:GDP relative level is too high, too low or just right at any point in time.  These elements are the relative level of interest rates and the expected sustainable GDP growth rate. 

In the graph below, I have plotted a line which is labeled the DOW:GDP Red Zone (dotted red line).  The Red Zone line makes an adjustment to the DOW:GDP measure for the systematic impact on stock valuations caused by changes in longer duration market interest rates.  The 20 year BAA investment grade index is utilized to assess the interest rate on overall market capitalization as it most correlates to stock market movement. 

Historically, as long as the gray line (DOW:GDP) stays below the red dotted line (DOW: GDP Red Zone), the stock market is not at high risk of a major pull-back.  However, once the market approaches and breaks through the red zone line, the probability of a major correction goes up exponentially.  At these points in time, economic growth, and the expectations for growth combined with the Federal Reserve rate policy becomes a major factor in dictating whether stocks can sustain all-time peak levels. 

You can see a good example of when the stocks were aggressively over valued relative to interest rates in the late 1990’s.  The graph area shaded in dark red shows how divergent market expectations became from reality in this time period.  Periods shaded in green reflect time periods when the stock market was undervalued relative to interest rates and the prospects for economic growth.   The stock market moved steadily higher in all of these periods shaded in green over the last 27 years.  It was the points in time after the warning zone was entered that stocks faced high correction risk.



(Author note: DOW:GDP Red Zone signals overvaluation risk leading up to every major stock market corrections dating back to WWII)

The stock market crossed over strongly into the Red Zone in 2017.  You can see this graphic indicator shaded in dark red in the upper right hand corner of the graph.  This happened against a backdrop of slowly rising interest rates prompted by Federal Reserve rate policy moves, and “yet to be fulfilled expectations” for higher economic growth.  Much of the current market expectations are pinned on hope, and hype, being created around the Trump economic plan and Tax Reform bill.

Given the alarming level in which stocks have been pumped up to, it is a good idea to check the relative levels of GDP growth and interest rates that are in place now versus previous stock peak periods of 2000 and 2007.  

Low Interest Rates Prop Up Stocks, Growth Expectations Push Valuations

 

The low interest rate market from 2008 through the present day is largely responsible for the reflation of the equity markets since the lows registered in March of 2009.  The fact that rates remained historically low for the past 9 years has provided a market environment in which stocks could recover on an almost uninterrupted path to the current levels at the end of 2017.

Compared to the two most recent stock market peaks, the interest rate environment currently is far less of a headwind.  But, the signature rise in rates that always precedes a break-down in stock prices has started to materialize in 2017.  The interest rate moves up preceding the year 2000 and 2008 market breakdowns was very pronounced.  Interest rates in year 2000 peaked above 6% on all Treasury maturities, and the BAA 20 year investment grade index approached 9%.  The heady rate levels in the late 1990s did little to squash stock market or economic growth expectations, until after the turn of the century.  Throughout this period the DOW:GDP adjusted for interest rates showed a very overpriced stock market.   The market eventually broke down after the turn of the century, and did not bottom until early 2003.

 

 

The interest rate moves prior to 2008 were aggressive, and the liquidity crisis that ensued as a result of the Federal Reserve actions from 2004 through 2007 was historic in proportion.  The banking system went into “cardiac” arrest as a result of the draconian interest rate moves first started by Alan Greenspan, but eventually completed by Ben Bernanke with 3 consecutive 25 basis point moves up after he was sworn in as Fed Chair in 2006.  The rate moves were driven mostly by the needs of the U.S Treasury to fund a two front war in Iraq and Afghanistan.  Meanwhile, the U.S. home U.S. economy was suffering, and many consumers were using their home equity as an ATM to fund on-going consumption, while their wage levels were not rising to amortize growing debt levels.  This combination of declining economic growth prospects in the midst of aggressive interest rate increases brought the DOW:GDP Red Zone level crashing down as the S&P500 crossed the 1500 level in 2007.  The market seizure that followed was epic, as two investment banks, Bear Sterns and then Lehman Brothers were both forced out of business.

In 2017, interest rates have begun to increase.  As a result the DOW GDP Red Zone, which had been steadily increasing as GDP slowly grew and interest rates continued to fall, has begun to reverse course from a peak of 1.2 times GDP to its current level of 1 times GDP.  This declining threshold sets-up the upcoming battle between the U.S. government, which needs to borrow more and more money to fund tax cuts and growing entitlement spending, and the stock market which must continue to grow rapidly in order to meet market expectations.

Real GDP Low and Flat versus 2000 and 2007 Warning Zone Periods

 

The burning question in the market today is will economic growth burst higher based on the Trump economic plan and the implementation of Tax Reform?    

The financial data since 1990 shows just how big the shift in economic growth has been in the U.S. since the 1990s, particularly the late 1990s.  In the late 1990’, real GDP growth of 4%-5% was expected, and these expectations fueled the stock market to heights well beyond economic reality.  Once signals of faltering economic growth began to materialize during the year 2000, the weak foundation for stock valuations began to collapse.  The smart money in this time period swapped into 10 year Treasuries at 6% and doubled their money over the next 10 years.   Stocks, by comparison, could not sustain a push above the 1999 and year 2000 peaks above 1500 until the year 2013.


Since 2013 economic growth in the U.S. has averaged 2.5%, and most recently continues to remain close to 2% on an annual basis.  There has been some optimism in the market generated by a 3% quarterly growth rate in the GDP in the 2nd and 3rd quarter of 2017.   However, the long term trend remains flat.

With stocks bursting higher in a situation where the growth statistics are not supportive of rampant optimism, the risk of market disappointment is growing with every stock tick up in the market.

Continued Lower Growth after Tax Reform Likely to Shatter Overvalued Stock Market

 

It is safe to say that the current U.S. equity market is highly leveraged, and I am not just taking from a borrowed fund standpoint.  The market is highly leveraged on the assumption that interest rates are going to remain low.  The market is also heavily leveraged on the idea that economic growth can push north of 3% on a real GDP standpoint on a 4 consecutive quarter basis, and remain at a much higher level in perpetuity.

The sad fact is that neither of these outcomes is highly likely at the present time.

The market will eventually resolve the present disconnection between stock values, the direction of interest rates and economic growth reality.  Should economic growth not fulfill the high expectations presently priced into the market, and interest rates continue higher, the set-up for yet another major market correction is in the cards.    Now that the market has moved into the DOW:GDP Red Zone, I expect a resolution to this issue to materialize within one year (Fall of 2018).  This estimate is based on how long similar highly extended expectations took to come crashing down in the 1999 and 2000 time period.

If you want to understand additional signals that will likely accompany the next major correction in the stock market, I recommend reading read my book, Theory of Financial Relativity.    You can also read additional articles reviewing current financial market conditions here


Daniel Moore is the author of the book Theory of Financial Relativity

All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.


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