A Check-Up on the Fundamental Roots of the Market

This week we want to revisit the stock market’s fundamental footing to see if there has been any improvement. We start with the price-to-earnings ratio (PE).

As the chart below shows, PE continues to increase and stands at 24.63 times earnings, which is more than 70% above the long-term average of 15. This, of course, is high, but it could go higher like it did during the tech bubble.

S&P 500 PE

Next, we look at the price-to-sales ratio, and as the chart below demonstrates, investors are willing to pay $1.89 for every dollar of sales which is more than at any time in the last 15 years.

S&P 500 Price to Sales

The price-to-book value ratio is almost at pre-great recession levels. Investors are paying $2.84 for every dollar of company value on the books.

S&P 500 Price to Book Value

The earnings growth-rate continues to be negative at -9%. It was worse at the end of 2015, but not by much.

S&P 500 Earnings Growth-rate

None of the fundamentals presented so far, can be used to justify the high equity valuations we see today, but are there any warning signs in the economy that might point to an impending recession and stock market collapse?

The percentage of banks tightening their standards on car, large corporate, and small corporate loans tends to rise as the economy works its way toward a recession. The chart below records this tendency going back to 1990.

Banks have been tightening their standards since the middle of 2015 (chart below).

Banks tightening their lending standards, implies that delinquencies are on the rise. The chart below shows that this, in fact, is the case. An increase in commercial and industrial loan delinquencies occurred just prior to the previous three recessions.

The next chart shows the total industrial capacity utilization going back three recessions. Just prior to both the 1991, and 2001 recessions, the capacity utilization dropped, stabilized, then dropped into the recession. In 2008, the capacity utilization stabilized near the cycle’s high then dropped into the recession. Starting in 2015, the capacity utilization has been dropping, and lately seems to be stable, which fits with the other pre-recession periods.

However, if we look at real medium household income (chart below), we see that household income dropped prior to each of the last three recessions, and that the latest income figures, up to Sept. 2015, show that income has been rising, which does not fit with an impending recession. Since we do not yet have the data for the latest year, we are reluctant to place too much emphasis on the one sole indicator that isn’t pointing (yet) to a possible recession, but it is worth noting.

In conclusion, most the fundamental metrics that we looked at, fail to justify the lofty equity valuations present in the market. Fundamentals have not improved, leaving interest rates as the sole driver of the high equity values. As long as funds keep flowing into equities and bonds in search of yield, the high valuations will be maintained. We see the market as increasingly sensitive to the upward bias in rates.

A rate hike has the potential to change the destination of money flows and, therefore, stock and bond values. . The CME Group FedWatch Tool is calculating a 70% probability of at least a 0.25% rate hike in December. Nobody is expecting a hike at the November 2 FOMC meeting, since this is just prior to the election, but it would be something if the FED did raise rates before the election. If the FED figures that the election is a forgone conclusion, which one hopes it is (for America’s sake), then they have no worries about influencing the election and are free to raise rates if the data is there. There is less than a 10% chance of this occurring, per the CME Tool, but we think it is more likely than that. A surprise hike would have a significant negative consequence on equity values.

The chart below shows the upward bias of all three parts of the Treasury curve, and the inverse relationship between rates and the SPX.