More on greed and fear (following the email I addressed last Thursday)
David Fuller's view The statisticians are telling us
that the S&P 500 Index is currently showing its strongest January since
1989. This has understandably raised an eyebrow or two among investors, so let's
take a further look at the implications.
Here is a historic chart of the S&P 500 Index to remind us that 1989 was part of a secular bull market, albeit sandwiched between the 1987 crash and the lesser correction in 1990. Assuming statisticians are correct, I find it interesting that the most persistent upward phase of that secular uptrend at the end of the 20th Century did not produce a bigger January gain.
Another factor of historic interest is that we have been in a secular valuation contraction during this century to date, as Fullermoney has often pointed out. Therefore, the strongest January performance for some time is interesting, not least with the S&P in the process of testing its 2000 and 2007 peaks.
I have also magnified a portion of the historic chart showing data from March 1983 through July 1990. You can see the January 1989 candle easily, if you just follow the grid line for 1989 up the graph. It was a good move but nothing exceptional if you look at the other upside monthly candles shown on this chart.
Interestingly, February 1989 briefly extended the gain before a partial retracement occurred that month. Today, we know that we have a short-term overbought condition that could easily produce a reaction in February. However, the more important question is - will the S&P soon confirm a third peak in this region and fall back sharply as we are still in a valuation contraction cycle? This invites another question - instead, might the S&P move to new all-time highs within a few months because the valuation contraction is ending due to record amounts of quantitative easing (QE), improving sentiment, the beginnings of a switch away from bonds, and lower valuations at these levels?
In other words, is there is any technical similarity between what we see today and the latter period of the previous valuation contraction cycle, for instance, between 1977 to 1980 for the S&P? I am not in the imaginative guessing game business and I know that the fundamentals are very different. However, I do think that the current valuation contraction phase has entered its latter years, and it is hard to be more precise than that. The only certainty is that the markets will show us.
Meanwhile, I can be more precise about valuations, following the 13-year contraction that we have seen to date. Here is another monthly chart of the S&P showing the last 20-years. I also have a historic PER chart of the S&P from Bloomberg. While I am unable to provide an overlay, you can see the bubble PER of over 32 in 2000. This more than halved to 17.5 at the 2007 peak. There was a brief spike in 2009 as reported earnings collapsed, particularly within the financial sector. Today, the S&P is within reach of its 2000 and 2007 peaks and the historic PER is still below 15. Similarly, look at this historic Yield chart of the S&P from Bloomberg. It fell to 1.05% in 2000 and was near 1.7% in 2007. Today, it is over 2.1%.
These valuations are a lot higher than what we saw in the early 1980s, as the previous valuation contraction period was ending. However, interest rates were much higher and there was no QE. Consequently, the risk of another big sell-off towards the 2008-2009 lows by the S&P 500 Index, which numerous financial commentators have been predicting since 2008, is much reduced in my opinion.
Moreover, as the present valuation contraction cycle ends within the next few years, it is more than likely to be followed by another lengthy valuation expansion cycle. This will be helped by a global economic recovery and continued growth, lower energy costs in real (inflation-adjusted) terms for many countries, plus the accelerating rate of technological innovation which will enable successful companies to considerably increase their earnings potential, whether they be large or small.