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After another day of excitement in New York, we have a correction. I have never been able to pin down the exact origin of the notion that a “correction” is a 10 per cent fall from peak to trough, but on this basis, we have one in the S&P 500. What I want to do now is ask as quickly as possible: have share prices really been corrected meaningfully or just by that arbitrary definition?
There is of course no such thing as a “correct” price for a share, or for an index of shares. A judgment of whether we have had a correction must remain subjective. If we use the cyclically adjusted price/earnings multiple championed by Robert Shiller of Yale University, and a good long-term measure of valuation, then this is not yet much of a correction. This is what the CAPE (which compares prices to average inflation-adjusted earnings over the previous 10 years) looks like:
I did a very bad job of drawing this chart in Excel, for which I apologise. That is why you cannot see the dates along the horizontal axis. These are monthly plots going back to 1881. I have updated the most recent plot for the value of the S&P 500 in the public spreadsheet that Prof Shiller keeps on his website, to take account of the latest action, and the good news is that the CAPE by this measure is down to 31.2. This is a level it last saw three months ago, but it is at least very slightly below its peak of 32.56 on the eve of the Great Crash of 1929. It is hard to say on this basis that prices have been “corrected”.
CAPE has for years been an outlier that shows the market to be more extremely overvalued than other metrics. So let us have a look at some of the more popular standard valuation metrics, in all cases using Bloomberg data. Here is the prospective price/earnings multiple, which has seen both a sharp fall in price and sharp rise in earnings expectations:
On this basis, we have had quite a correction, eliminating the past four years of overheatedness. and we are back to a level seen in early 2014. But if we look at trailing multiples, the correction is much less impressive:
This looks merely like a recovery after a brief rush of blood to the head. Valuations are where they were a few months ago.
If we take multiples of book value, on which the effect of the tax cut will be less dramatic, prospective multiples again do not look as though they have had much of a correction:
It is a sharp snap back that still takes us only as far as the eve of the final negotiations over the tax cut. Looking at some of the most fundamental metrics, this sell-off has not left the market looking any significantly less overblown in terms of free cash flow multiples:
And on the basis of dividend yield, the market does not look very attractive at all, even after the sell-off. This is the dividend yield on the S&P 500, with the 10-year Treasury yield for comparison. If stocks were bid up because their dividend yield could compete with the yield from bonds, it looks as though they would need to sell off very much more before stocks became attractive for their dividend yield again:
If we look at the market in terms of technical patterns, then there has certainly been a radical shift in terms of the proportion of stocks that are advancing or declining. A few short days ago, advancers swamped decliners, in a classic sign of excess. Now (according to this chart from Bespoke Investment) it looks as oversold on this basis as it has done in a year:
But remember the last year was an extraordinary year of historically low volatility. For decliners to outnumber advancers to this extent does suggest that stocks should be ready to bounce, but this is nothing unprecedented. What is unusual is for the market to have gone this long without spikes of selling:
Now let us look at the internals of the market. Usually during a big correction, it is the stocks that have grown most overvalued that fall the most. Those winners that have carried on winning and reached excessive valuations thanks to the power of momentum suffer an emphatic reverse. Very intriguingly, that is exactly what has not happened this time.
The NYSE FANG+ index of the most popular internet stocks continues to easily outpace the market, thanks in large part to the excitement around Netflix and Amazon so far this year. And the "momentum" style — which involves holding those stocks that have been winning recently and avoiding relative laggards — also continues to beat the market comfortably. There has been no reversal here.
If cheaper stocks show any more attractive valuations, this has not yet helped them. The growth style (buying stocks with durable and growing earnings) continues to outpace the value style, although value did have a slightly better day on Thursday:
And if we move back to the bond market and inflationary fears, which still in my view seem to be the obvious catalyst for the disruption of the past week, it is not clear that they have yet moved that emphatically. The critical measure is the real yield — do bonds yet offer an appealing yield over and above expected inflation? (If they do, the implicit inflation protection involved in stocks becomes less attractive). In the past few days there has been a noticeable tick-up in real yields (which I calculated by stripping out the 10-year break-even rate away from the 10-year nominal yield).
So the Treasury market could be said to be making conditions a little tighter. But if we look at the real yield over a longer time horizon, we can see that it could go much further. This stock market reaction looks more like a response to the growing risk of higher real yields in future, rather than a reaction to an accomplished fact:
If we look at recent trading patterns, the sell-off so far has brought the S&P 500 back to the middle of its recent (very positive) trading range, after a few weeks of excess in the wake of the tax cut. I have marked what was a very clear trading range starting from the sell-off at the beginning of 2016 on the following Bloomberg screen shot:
Where does all this leave us? If a “correction” means a correction to the obvious excess that followed the tax cut, then this is a correction. Genuine market euphoria at last made a belated appearance once the tax cut was passed, and that euphoria has been corrected.
If by “correction” we mean something more deep-seated, re-positioning stocks for a secular rise in bond yields and correcting for the overvaluation that had been apparent in many measures for some years, then this cannot yet be called a correction. Friday’s trading looms as an important indicator of which way the market goes. And then the market will have a Valentine’s Day assignation to look forward to. The next US inflation numbers come out on February 14. It could be a very Funny Valentine.
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