Current Conditions Typical of Market Peak Comstock Partners, Inc. Friday, January 20, 2006
A study of past bull and bear cycles indicates that cyclical peaks and troughs exhibit repetitive and consistent behavior that helps determine whether the stock market is closer to a top or a bottom. Market bottoms typically are accompanied by low valuations, highly negative investor sentiment and an easing monetary policy. By way of contrast, market peaks usually exhibit high valuations, positive investor sentiment and and tightening monetary policy. In addition, by definition market peaks occur following substantial gains while bottoms occur after significant declines. In our view the current status of these factors strongly indicate that current market conditions are much more typical of a top than a bottom. Valuations are high, investor sentiment is positive, the Fed is tightening, and the market has risen significantly over the last three years.
For about 100 years through the late 1990s the P/E ratio of the S&P 500 ranged between a high of about 22 and a low around 8, with an overall average of about 15. In the late 1990s bubble the P/E ratio soared to over 40, and has now declined to 18.3, a valuation that is still in the high end of its historical range. If the P/E ratio drops only to its long-term average of 15, the market decline would amount to 18%, even assuming the current record earnings levels remain intact. Furthermore a decline in the P/E to 8 would result in a severe market drop of 54%. (In the post-war period bear market declines have averaged about 30%.) On the other hand if the market does not drop sharply, the valuation problem is likely to be resolved only by a multi-year trading range resulting in little or no net gain. In the past, investments made at the upper end of the P/E ratio range have resulted in anemic returns even over periods as long as 20 years.
The current market is also characterized by optimistic investor sentiment despite the worries about Iraq, terrorism and high energy prices. According to Investors’ Intelligence 57% of market letter writers are now bullish and only 23% bearish, numbers that are typical at bull market peaks. At bottoms, on the other hand, the percentage of bulls is generally under 25% while bearish sentiment is more than 50%. The percentage of cash as a percentage of assets in equity mutual funds is now only 3.9%, the bottom of a 40-year range encompassing a high of about 13% and a low of around 4%. In addition the current VIX volatility index is now at 11.9, indicating a lack of investor concern about market risk. Over the last 15 years VIX has fluctuated in a range between 10 and 47. Although we prefer factors that can be measured, even on an anecdotal basis it is easy to see the rampant bullishness in the media and on the Street. Viewers of financial TV shows are well aware that it seems extremely difficult to find enough bears for a vigorous debate.
Turning to monetary policy, the Fed has hiked the funds rate by 25 basis points 13 times over the last 19 months bringing the rate up to 4.25% from its low of 1%. Since the Fed came into being in 1913 the vast majority of tightening phases have been followed by bear markets. These bear markets generally did not end until after a policy of ease was well under way as investors at the start of a move toward ease typically become more concerned with the prospect of falling earnings than with the intricacies of Fed policy. When the market finally turns up in response to Fed ease it is only after a significant decline, negative investor sentiment, and far lower valuations.
In our view current high valuations, optimistic investor sentiment and tightening Fed policy mean that market risk is extremely high and potential rewards on the low side. In saying this we are well aware that a large segment of the Street and investing public believe that this time it’s different; that people who believe this are often intelligent and well-informed; and that they present seemingly logical arguments. However, the belief that this time is different has always been the case put forward at market peaks. That is why the peaks occur in the first place. Publicly traded markets of any kind simply cannot soar to high levels without a widespread belief that those levels are justified. Once that happens, though, the potential risk/reward ratio shifts heavily to the downside, and that is where we think we are today.
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