As we approach the midpoint of the year, and after a strong rally in parts of the market, an exploration of where things currently sit is warranted. After all, first we have to know where we are before trying to figure out where we’re going and how we might get there.
The most straightforward measure of current conditions is valuations, particularly the price-to-earnings ratio (PE). Some may argue that PEs don’t matter as much as they used to, or that they’re not the right way to gauge risk and direction, but they remain one of the most easily measurable metrics for stocks. And when we’re trying to make rational investment decisions for the long term, measuring things is important.
Since March 13, when the regional bank stress was at its peak, the S&P 500 is up over 13%, the Nasdaq is up over 20%, and the Nasdaq 100 (the largest and most active non-financial companies listed on the Nasdaq) is up almost 25%. It’s no surprise that during the last couple weeks we started to hear more and more about stocks having gone “too far, too fast” or approaching overbought conditions.
But how do we know for sure? That’s the fun of it, we never know for sure. Maybe my definition of fun is different from yours…in any event, as things stand today I can say that PEs feel high, at least for the broad S&P index.
The broad index PE is currently above its 5-, 10-, and 15-year averages. High, but not as high as some extreme measures of the past, which begs the question…does it have even more room to run? Perhaps.
When I was in school, which is starting to feel like a lifetime ago, I remember math teachers defining the slope of a line as the “rise over the run,” and that catchy phrase runs through my mind often to this day, and even more often lately.
How quickly a line rises vs. how long it took to get there (the “run”) is not a metric that we can mathematically determine is too fast, too slow, or just right. But we can visualize it on charts, and compare it to prior quick rallies.
The issue with this is that the dispersion of results is wide. After rallies of 15% or more that occurred over a 3-month period, the Nasdaq has posted decent results more often than not over subsequent 6-month timeframes, but the results are below average and the max is well below average. In other words, the takeaway is mixed — average returns following a sharp rally are positive, but unimpressive. And there remains a chance for outsized negative returns.
Momentum is a powerful force and it can carry markets upward for long periods of time, but it shouldn’t be confused with durability. This environment of Fed tightening and shrinking liquidity may not be friendly to steep upward sloping lines.
The last metric worth mentioning is the number of stocks trading above their 200-day moving average and how it’s improved over recent weeks. This is a measure of breadth, and one that wasn’t looking very promising just a few weeks ago, but it’s improved notably in June with now more than 60% of S&P constituents trading above that threshold.
After many weeks of only a handful of big stocks leading markets higher, the participation of other stocks in this rally is a welcome change. But it’s not quite enough to be convincing of a new bull market, when 80-90% of constituents are typically trading above their 200d MA for most of the first year off a major bottom.
That could mean that we’re still fighting our way into a new bull market and there’s room to broaden out from here, or it could mean we’re still in a longer-term downtrend with maddening headfakes along the way. Oddly, the metric above that draws the least clear conclusion, the slope, is the one that nags at me the most. We won’t know until we know whether this is a new bull or a pesky bear, but the steep slope of the line upward makes me uneasy, and reluctant to flip into bull mode.
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