Leading Investment Indicators

In economics, leading indicators are measures that typically change before the economy as a whole changes, thus providing some predictive power with respect to what lies ahead.  For example, the Conference Board publishes a Leading Economic Index intended to forecast future economic activity.

My intent here is to derive some Leading Investment Indicators.  Unlike leading economic indicators, these are not designed as short-term predictors.  The strength of these metrics is as a tool to measure potential real long-term returns.  Thus they are better used as longer term indicators of value, risk and expected returns. They in no way should be used as any sort of timing mechanism. The stock market can continue higher regardless of what any metric of valuation is showing. These indicators are designed to be a helpful tool to help shape an overall investment thesis and process as well as to separate short-term and long-term concerns, not to dictate trading decisions.   

1. PE10.  The largest contributing factor to equity returns is the P/E ratio. The expansion or contraction of the broad market P/E ratio creates secular bull and bear markets. The chart below from Crestmont Research breaks down the components of total return for the S&P 500 for ten-year rolling periods.

Yale Professor Robert Shiller’s 10-year Average Inflation-Adjusted PE Ratio, also known as CAPE or PE10, provides the best longer-term market gauge available. PE10 is the stock index price divided by the average real earnings from the previous 10 years – the time period is designed to smooth out near-term noise in the data.   The basis for this approach is the finding that earnings valuation ratios provide predictive power for long-term stock market returns.  Campbell & Shiller, “Valuation Ratios and the Long-Run Stock Market Outlook.” Journal of Portfolio Management 24, 2 (Winter 1998), pp. 11–26. 

The long-term mean CAPE as calculated by multpl.com using Prof. Robert Shiller’s data is 16.42.  In January 1921, PE10 was 5.12, the lowest value of any January in the historical period. Meanwhile, PE10 in January 2000 was 43.77, the highest January level in history. It is 20.42 today, suggesting that stocks remain significantly overvalued.  Historical S&P 500 PE10 is charted below.

Source:  multpl.com, using Prof. Shiller’s data

2.  DY10.  The dividend-price ratio or dividend yield (DY) is another predictor of the subsequent 10-year real returns on stocks, although this approach has its problems.  Historical S&P 500 DY is charted below and suggests that stocks are significantly overvalued today.

Source:  multpl.com, using Prof. Shiller’s data

3. Tobin’s Q.  The Tobin’s Q is the ratio of price to replacement cost, which is in many ways similar to book value. See Tobin & Brainard, “Asset Markets and the Cost of Capital,” Economic Progress, Private Values and Public Policy (1977).  The most current Q ratio can be calculated from September’s release of the Flow of Funds report for Q2 2011. It is calculated by dividing line 35 of table B.102 by line 32. The historical data is also available on the St. Louis FRED website.  However, because the Flow of Funds report is released long after the quarter end, the Q ratio used herein has been adjusted for the change in stock prices since the most recent report.  When equity as a percentage of GNP is above-average then total real returns for U.S. equities have a high probability of being below average. When equity as a percentage of GNP is below-average then total real returns for U.S. equities have a high probability of being above-average. Another use for Q is to determine the valuation of the whole market in ratio to the aggregate corporate assets. The Q ratio is a statistical measurement of the market’s value; fair value for Q is 0.65, primarily because capital stock is routinely overstated leading to a larger denominator in the Q equation. See Smithers & Wright, Valuing Wall Street : Protecting Wealth in Turbulent Markets.  

Tobin’s Q currently sits at 1.01, suggesting that the market is significantly overvalued (as charted below). Indeed, many proponents of Q as a measurement suggest selling when Q rises 50% above fair value; Q is 55% above fair value currently. 

4.  Market Cap to GDP.  Market Capitalization to GDP has been described by Warren Buffet as “probably the best single measure of where valuations stand at any given moment.” It compares the total price of all publicly traded companies to GDP. This metric can also be thought of as an economy wide price to sales ratio. The data here is from the St. Louis FRED. However, because the data is quarterly, data for the other months have been entered using the prior ratio adjusted for the change in stock prices.  As charted below, this metric suggests that stocks are significantly overvalued.

Source:  Vector Grader

5. Bond Yields.  Returns on bonds depend on the initial bond yield and on subsequent yield changes. Low bond yields tend to translate into lower returns because of less income and heightened interest-rate risk.  As Warren Buffett has pointed out (although he is not alone in this), “interest rates act as gravity behaves in the physical world. At all times, in all markets, in all parts of the world, the tiniest change in rates changes the value of every financial asset.  …If interest rates are, say, 13%, the present value of a dollar that you’re going to receive in the future from an investment is not nearly as high as the present value of a dollar if rates are 4%.”  As charted below (although the chart doesn’t go back that far), nominal treasury yields have been generally declining for roughly 30 years, suggesting that all assets are at risk going forward.

Source:  U.S. Treasury

When viewed in fuller historical context (shown below), the risk may not seem quite so high.

However, the 10-year note yield hit a record low yield of 1.974% on August 18, 2011.  Since 1962, the 10-year yield has only been below 2.4% during the financial crisis of 2008, in December 2009, in January 2010 and recently.

These measures all confirm what I have been saying for a long time (for example, here and here) – we are (since 2000) in the throes of a secular bear market, subject to strong cyclical swings in either direction.   I continue to encourage investors to be skeptical, cautious, and defensive yet opportunistic. I suggest that they look to take advantage of the opportunities that present themselves while carefully managing and mitigating risk.  Now is not the time to get greedy.

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