Should You Be Worried About the Stock Market?

Should You Be Worried About the Stock Market?

I’m not worried about my daughter’s incredibly chubby cheeks. But I am worried about the stock market…

Here’s the intriguing bit though: I’m worried and not worried about them for the same reason. Because of something called ‘percentiles’.

My daughter is in the 50th percentile for her bodyweight, given her age. Always has been, depending on the timing of the daily poonami.

This means she’s bang on average in terms of her weight, for her age. 50% of babies her age are heavier and 50% are lighter. This is despite the fact that a very large chunk of her bodyweight can be found in her cheeks.

She doesn’t need a pillow when she falls asleep on her front. And when she’s in her baby carrier, she can’t move her head around much because her cheeks get in the way. When the pram hits a bump, it takes a while for her cheeks to catch up to the rest of her body, after which they continue to bounce around independently.

But that 50th percentile suggests they’re a temporary feature, not a signal of a future career in sumo wrestling.

But what does the same measure say of the stock market? Which percentile is it in?

This sounds like an odd question, I know. Stock markets don’t weigh anything. But there are measures you can make of stocks to determine which percentile they’re in compared to their historical norms. And you can compare between stock markets around the world too.

For example, given the level of profits companies are making, are share prices high or low? (The premise being that investors invest for a claim on company profits.)

If share prices are unusually high given company profits, in the 99th percentile say, you would expect the stock market to perform poorly in coming years. Share prices have risen faster than profits and must wait for profits to catch up, or the prices must fall.

99th percentile, in this context, means that share prices have been lower relative to profits 98% of the time, historically speaking. It’s a measure of unusualness. And 99th percentile is very unusual.

Yes, I didn’t pull that number out of a hat. Based on expected earnings in the next 12 months, and current prices, US stocks are in the 99th percentile.

But what does that mean?

Market expert Shae Russell predicts five knock-on effects of the recent market crash that could be even bigger threats to the average investor’s wealth than the crash itself.

Well, it allows you to project what stocks should do if they were to return to ‘normal’ — the 50th percentile, say.

The master of such matters is John Hussman, an American fund manager who takes analysis like this to the extreme. And here’s what he wrote two weeks ago:

The S&P 500 has rebounded to within 6% of the most extreme level in U.S. history, to valuations that – on the measures we find best-correlated with actual subsequent market returns – again rival the 1929 and 2000 extremes.

We currently project negative S&P 500 nominal total returns on both 10-year and 12-year horizons. Our estimate of likely 12-year total returns on a conventional passive investment mix (60% S&P 500, 30% Treasury bonds, 10% Treasury bills) is now also negative, at -0.10%. That’s lower than every historical extreme, including August 1929, except for the first three weeks of February 2020.

Current valuation extremes suggest that the S&P 500 could lose about two-thirds of its value over the completion of the current market cycle, even without moving below historically reliable valuation norms.

In other words, American blue chip companies’ share prices could fall by 67% without this being ‘unusual’ compared to their historical valuations.

If all that seems oddly precise, consider that it’s not intended to be an accurate prediction. The argument Hussman makes very carefully and well is that, given where we are now in markets, and comparing this to the past, you should expect a simple portfolio of stocks and bonds to perform very badly if things return to ‘normal’.

It’s a bit like working backwards to figure something out. It also makes intuitive sense. The higher share prices go relative to profits, the less high you should expect them to go in the future. Reality matters, eventually. And that allows you to establish what you should expect from the future, based on how far we have diverged from what was normal in the past.

In other words, if my daughter was in the top percentile in terms of her weight, you should expect her to be overweight when she grows up.

Unless you take action.

But what action do you take in the stock market, when it’s at dangerously high percentiles for valuations?

Overvaluation can last a long time. And it can always become more extreme in the short run.

But I think Hussman’s point is that, those who are using a buy and hold strategy should be looking elsewhere right now. They could, for example, look outside overvalued stock markets like those in the US.

What about the Aussie market?

Well the All Ords doesn’t look too bad:


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Source: Marketindex.com.au

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But this ASX 200 forward looking P/E ratio might’ve warned you of trouble in 2019…


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Source: ABC

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Where to instead then?

Not Germany. This chart shows DAX valuations are especially sky-high.


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Source: Twitter

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But valuations are very low in parts of the Japanese stock market. Perhaps the Japanese have just got their deflationary shock and stock market morass over and done with already. The cult of equities that bid up markets died in the 90s.

Of course, to get that low the stock market had to fall for decades. Even the Japanese haven’t figured out how to fix that.

If you ask me, the decades of broad stock market gains are over in the US and Australia. You either have to target specific sectors which will outperform or look elsewhere for gains.

But where?

Until next time,

Nick Hubble Signature

Nick Hubble,
For The Daily Reckoning Australia