On May 3, 2013, more than thirteen years since its first close above 1500, the S&P 500 closed above 1600 for the first time, at 1,614.42. Last week it closed at 1,667,47, some say by the end of the summer it may reach 1700 points. There has been a lot of talking lately about the S&P 500 being overvalued, or about its latest rally being a bubble (Zero Hedge’s Tyler Durden inspired us with the 80% correlation between the Fed’s balance sheet and the S&P500 article) caused by Bernanke’s money-throwing, and indeed it had a minor fall at the news that the FOMC sooner or later will have to slow the liquidity-pumping a bit. Surely the hunger for growth and the #EquityBull (writing it like that has a subtle slogan-ish meaning) cornucopia they have been announcing like Jehovah witnesses since 2010 (2009 even) has played a role in expectations – self-fulfilling prophecies. Anyway we had an idea: why don’t we look at the data instead of blabbering about like a bunch of amateurs? Feelings and rumours are good proxies for market trends only when we don’t have any other tools available.

We took Shiller’s data (S&P500 collected every month from January 1871 until May 15th, 2013) on his Yale page and daily data from S&P Indices website and started plotting them. The first idea was to look at some relative valuation, so PE and CAPE – that is a fancy modification of PE Shiller made famous, adopting a theory first elaborated by Dodd and Graham; it basically smoothes the PE putting at the denominator a moving average of 20 years’ earnings: as a result CAPE is way less volatile, as we can notice by the absence of the 2008 spike, arguably due to a fall in earnings and definitely not to an increase in the index.

If we take a look at them, apart from a spike around 2008, we see it has been relatively high since the beginning of the 90s, but it does not seem very high at all  if compared to the last 20 years. So at least from an earning perspective, the market is not overpaying anything, unless we want to argue the index has been overvaluing earnings for more than 20 years.

But all this talking must have been triggered by something. So we had a look at the hardest and rawest data possible, the point index itself. To be honest, we do see an all-time high right there. But that’s nominal. So we took the CPI (Consumer Price Index) and adjusted the values taking into account the ratio between the CPI today and the CPI every year of observation (a little nuisance called inflation), and we found with not great surprise is that today’s value is not an all-time high level (red line is real index), at least if we are talking money seriously. What it indeed is, is a post-crisis high, that’s all. In real terms the index already touched 2000 a couple of times.

What we can say here, instead, and we think it is much more important than record-breaks, is that the definite trend we observe since 2009 is very reminiscent of the 2000 and of the 2008 pre-crisis path. Those two and the 2009-today upward trend are the fastest growth patterns the index has seen in its life. And the first two have been followed by the biggest (real) downfalls in the history of the index. Curious enough, that is something we still have to hear from prophets.

If we look at (real) returns (log and actual are plotted: you see an orange line because logs are red and actual are yellow and as you can see they differ only in huge spikes), we see they haven’t been that definitely above zero all the time. If you look at returns from 2009, they are hardly constant/consistently above zero for long periods of time.

You may think “Ok these are monthly returns, we are looking at just 6 consecutive overall bullish months, but compounded they make a huge bull, it’s just that you don’t spot it eyeballing the returns series!”. Assumed you do not like to look at the index again to see the actual trend (it “keeps” all the shocks indefinitely so that would be where to look for eventual paths – but anyway), we computed 6-month geometrical averages to see, every month, what gross (log) return the past 6-month path has generated. This way we should spot bull-paths, and could try to locate bubbles spotting unusual high values (whereas, in the return plot, overvaluation could hide in several consecutive points – i.e. monthly returns – being above zero, but without them exhibiting a definite upward trend).

You see it right there, upward-shaped from August 2012 and heading to the ceiling. Almost so. If it wasn’t for the fact that the same shape appears nearly every year (take out 2007 and 2008). This may be the start of an incredible bubble, but from now all we can see is an usual path (a so usual one it originated an oft-quoted saying “Sell in May and go away” even if this year someone talks about an April report by Goldman Sachs recommending not to sell out in May, and to overweight equity instead), not an exceptional one.

Now let’s look at volatility and see if recently investors have just gone bananas and irrationally did we-don’t-know-what, if this is all a giga short-position-closing or whatever Tyler-Durden-like idea we might think of, related to volatility. We took the levels of monthly (VIX) and 3-month (VXV) implied volatility on the S&P500 options as measured by the Chicago Board of Options Exchange.

There have been a couple of spikes (year’s end, mid-February and mid-April), but hardly as high as uncertainty levels during June 2012, 2011 Fall, 2010 Summer. This means market is not expecting the index to fall or to abruptly change trend, neither in the forthcoming month (VIX) nor in the next 3 months (VXV).

To wrap it all up:

  • PE is fine, not high at all and without any worrying features
  • Levels are high but not an all-time high. Worrisome 2000&2008-reminiscent features
  • Returns do not appear unusually high, or constantly above zero
  • 6m compounded total return is high and may look suspect, if compared to similar past paths (March 2012, January 2011, September 2009), but not so evidently
  • Volatility is fine, but has been quiet for a while, compared to historical behaviour

Our opinion on overvaluation is that due to the “worrying features” in the levels path, we would not completely rule out the bubble argument, but at the same time we are far away from being willing to bet on it. We still have the Fed throwing money (they still will, only thing Bernanke said was “we’ll have to slow down one day, you know” and that is probably going to be at the end of the year/beginning of 2014, and anyway under the somehow-not-agreeable hypothesis that recovery is finally and soundly here). We would not imagine the growth to stop immediately. But what is more important than this, is what investors think will happen.

Our views on what the market is thinking: the index obviously will not fall dramatically in the next months, but slowdown expectations in late May (next week)-June. Then it will eventually record some red candles after some lower-than-overexpected Q2 results (bulls may be focused on the big ride up and will incidentally become nervous after some so-and-so earnings reports), and quiet recovery by July/August. Continued growth and continued nominal all-time highs until September, when inevitably earning won’t be able to live up to such bullish expectations, and growth may seriously stop there for the year. Then we will be at a crossroads: Bernanke will probably fire another bullet out of his beloved breviary “How not to have yourself understood by the whole world” (aka Fedspeak), and we’ll know if they think it is prudent to slow down money supply. All this amid fears of a big short (after the bullish year so far), because the market has never grown like that for so long without falling miserably at the same rate. Uncertainty.

Our Brave Final Word: long all the way until September, buy in high 1.630s if reached again in the next two weeks. Otherwise long it anyway in the following two weeks (say by the third week of June you should have it in your pf). After the VIX went up until 15,5 on Bernanke’s words (now it’s down to 14-some), if one was feeling excessive amounts of testosterone we could think of a way to exploit the uncertainty around, shorting puts (immediately, this way we cash volatility in, hoping that it will not increase).

1 Comment

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