Each week, we tap the insight of Sam Stovall, Chief Equity Strategist for S&P Capital IQ, for his perspective on the current market.
EQ: In this week’s Sector Watch report, you took a look at the market possibly hitting a top as we near the all-time high on the S&P 500. While digestions and pullbacks are pretty normal, corrections and bear markets are not. Still, there have been 19 corrections and 12 bear markets since 1945, which seems like these drops are more frequent than investors may realize. Do you agree?
Stovall: Yes, I do. While investors today are talking increasingly about the possibility that the U.S. equity market is ripe for some sort of decline, I wanted to remind investors that declines are part of the normal operating procedure. Since World War II, we have had declines of 5 to 20 percent happen just about every year. There have been 75 such declines, so you have to realize these declines are fairly regular occurrences. However, bear markets are not regular occurrences, so I wanted to find out if the market’s valuation, economic situation, monetary positioning, etc. indicated if we are ripe for a decline of 20 percent or more. Much to my pleasant surprise, these indicators did not point to an imminent bear market.
EQ: Interestingly, you found that historical valuation levels were not very useful as an indicator of a potential market top. Why is that?
Stovall: The interesting thing is that if you look at a variety of economic and monetary valuation measurements—or basically all the things that people talk about when they’re on TV—a lot of them, by themselves are not very good at helping us decide when is a good time to get out of or get back into stocks. There have been two times since WWII in which a bear market started when the P/E of the S&P 500 was below 10. Obviously, we remember the late 1990s when we peaked out, but the P/E on the S&P 500 was close to 30 at that time. That was probably a no-brainer. However, in the 1970s, and also in the late ‘40s, we had a period in which we peaked out with a P/E ratio that was less than 10. The things that were in common with a low P/E and a market top were high inflation and high interest rates. So you really can’t look at things in isolation to say if the market is either ready to take off or collapse. You have to look at the entire picture.
You have to look at factors such as the age of the economic expansion, whether interest rates are rising and how high they are, what the inflationary environment is and where it’s heading, and then at valuations to see if they’re vulnerable to a market top. You have to look at all those different factors. To me, the only thing that seemed to stand out to indicate that we were ready for some sort of a decline in share prices was the percent difference between the S&P 500’s value today and its rolling 50-day moving average and 200-day moving average. We are well above the average since 1948, though we’re not near the typical peaking point, however. This means that we have not gotten to levels of extreme excessiveness. That said, I think we are at levels in which the market is definitely due for some sort of a breather.
EQ: One telling sign is the lack of volatility. Can a calm market actually be a bad thing for investors?
Stovall: Yes. I’ve done a study going back to the 1950s, and the premise was that you could look to volatility the way a volcanologist looked at seismic activity. So if you have an increase in the number of earthquakes, then the implication was that the volcano was ready to erupt. Well, in the stock market, I have found that increased volatility is more of a coincidence or even a lagging indicator, and that the peak in volatility usually comes one month before the end of the overall decline. I found that you should actually look to volatility the way somebody who is watching out for a tsunami looks to low tides. If it’s an exceptionally low tide, then it means that it might be time to run for the hills.
I have found that at least since 2000, whenever we have looked back 20 business days and have found fewer than three times in which the intraday volatility was greater than 1 percent, the market was getting complacent and eventually we would end up with a market decline of 5 percent or more. That has happened every time since 2000 in which very low level of volatility implies that in the next couple of weeks or months we ended up with a subsequent decline of 5 percent or more. While it’s not an exact timing model, it is a matter of when and not if.
So my belief is that while we are ripe for some sort of digestion of the recent market gains, based on these indicators, the decline that we end up with will probably be more on the order of a pullback or a mild correction rather than a beginning of a new bear market.
EQ: How does the current state of the economy’s health compare to those of previous market tops? What does that tell us?
Stovall: Previously, if you look to all calendar years since 1948, the U.S. economy has grown at a real rate of about 3 percent per year. At market tops, we’re usually looking at economic growth that is about 4 to 4.5 percent, which is certainly higher than the average. Well, in the most recent quarter, we saw an annualized rate of -0.1 percent. Most economists, our own included, believe that when we get revised fourth quarter 2012 numbers, we’ll probably end up on the low-positive side. So while it gets rid of the negative first reading, it’s still not indicating that we are at any level of excessiveness whatsoever and that this half-speed recovery, which we’ve been calling it since June 2009, continues to be the case. Our belief is that we’ll probably start to see the trajectory of this economic recovery increase a little. and so S&P is forecasting a 3 percent increase in economic growth in 2013, which would mean that we’re just getting back to normal and not to an elevated stance.
