With each passing month, it's becoming evident that the current bull market has slowed from a gallop to a trot.
The S&P 500, which rose 29% in 2013, will likely trail such a gain this year, as it is up only 7% in 2014 as of September 15. And by one key measure, the bulls advance may cease altogether, potentially resulting in a market reversal.
Make no mistake, the market has been in rally mode for more than five years in large part due to the Fed's easing hand, which is fueling ultra-low interest rates and ample liquidity for stock buying. Yet it's always wise to keep an eye on traditional market metrics, in case the market starts to become fully disconnected from the fundamentals.
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Each investor can focus on their own sense of fair value. For example:
-- Some investors like to compare the dividend yield on the S&P 500 to federal fund rates. The current dividend yield stands at around 2%, higher than short-term interest rates. Still an eventual upward move in short rates will pressure this valuation gauge.
-- Other investors like to see how stocks are trading in relation to their private market value (i.e. what they would likely fetch in a buyout). Private equity historically acquires mature business at 4-to-6 times trailing cash flow, and growth businesses at a somewhat higher multiple. Fully 83% of the companies in the S&P 500 are trading for more than eight times trailing cash flow.
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-- Other investors like to focus on EPS growth. Per share profits have been enhanced in recent years by massive share buybacks -- a trend that may not last. If buyback activity cools, underlying net profit growth will come into greater focus. Many companies in the S&P 500 are seeing profit growth slow to less than 10% as the low-hanging fruit of streamlining efforts disappear.
Warren Buffett has an easier way to gauge the valuation of stocks. He thinks that the combined value of all stocks -- as measured by the Wilshire 5000 Total Market Index -- should be worth less than the Gross Domestic Product (GDP) of the U.S. economy. And this ratio has typically generated a sell signal whenever it gets out of whack. It happened in 2000 and again in 2007, and though the market marched higher after crossing that threshold, the 12-to-18 month outcome was fairly bleak.
Unfortunately, we're back into the danger zone. The stock market's total value surpassed GDP in March 2013, and is already beyond the point it stood in early 2008, just before the last major market pullback. As this chart from financial blogger Doug Short shows, the market is now more than 15% overvalued, at least according to Buffett's gauge. This gauge actually rose above 135% in 2000, and the dot-com melt up turned out to be a painful experience for most investors.
To be sure, "this time is different" is a mantra that you'll hear on Wall Street trading desks. These traders suggest that corporate profit margins have never been higher and companies now deserve higher valuations.
Here's the problem with that logic: Profit margins often peak in the early stages of an economic recovery as companies skimp on spending. Indeed work forces remain lean and capital spending has been depressed, but as an economy starts to strengthen, many companies amp up their rate of spending and profit margins return back to Earth.
Still, investors can remain bullish as long as per share profit growth remains robust. Will that be the case? It's hard to know how the U.S. economy will be faring in 2016 and beyond as China, Europe and our own economic cycle remain as major question marks. But we can at least gauge EPS trends before then. According to Factset Research, the projected earnings growth rate is 7.3% for the S&P 500, rising to 11.5% in 2015. Double-digit profit growth will likely only happen if the U.S. economy grows at a 3% pace next year.
S&P 500 Profit Growth & P/E
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