Rule of 20 Signals Stocks Are Expensive

Final 5 Bear Market Signposts

Let's review the bear market signposts individually to see if they imply a bear market is coming. 11 of the 19 warning signs have been triggered. In previous articles, I’ve reviewed the first 14 of them and determined that 4 are unreasonable, meaning less worry should be given about an oncoming bear market. The 15th signpost is the yield curve inversion which we’ve discussed many times. This is the best indicator of an oncoming recession. It doesn’t catch every market peak, but it has a hit rate of 88% since 1962, with 1970 being the only time there was a bear market without an inversion within 24 months. The great part about this indicator is it doesn’t have false positives, like many of the others listed below. The latest difference between the 10 year bond yield and the 2 year bond yield is 52.5 basis points. It has inched closer to an inversion since this list was published. My target for an inversion is between the 2nd half of 2018 and the 1st half of 2019.

The 16th bear market signpost is the change in long term growth expectations. It’s triggered when the expectations increase by more than 0.6%. Since they have risen by 1.9%, this signpost has been triggered. Since 1986, this signpost has a 100% hit rate. Aggregate earnings growth estimates tend to rise within the last 18 months of bull markets. To be fair to this bull market, analysts have increased estimates, albeit by not enough to trigger the sell side signpost, because of the recent tax cut. It’s tough to say if this indicator means a bear market is coming because aggregate estimates are overzealous or that they are just accurately portraying the effect of the tax cuts. With a lower tax rate for the long term, margins will increase. The countertrend to this is potentially increasing financing costs. The tax cuts are near certainty while the changes in interest rates aren’t. This would cause the net effect on long term earnings expectations to be positive.

The 17th signpost is the rule of 20. This is a valuation rule. The rule is that the trailing price to earnings multiple plus the year over year change in the CPI must be over 20 for the trigger to go off. Since the total is 22, it has been signaled. This is a decent crude estimate for how expensive stocks are because it also looks at inflation. The main driver of this trigger in this market is the high PE. This trigger has gone off within 12 months of every bear market since 1960. This signpost is the perfect type of crude warning sign to add to a long list like this. It would be silly to look at this indicator on its own, but when you have a bunch of crude indicators moving in one direction, it tells you something. Technically, every indicator is crude in general because no one knows the future. Nothing can predict the future with absolute certainty. The point I make by calling this one crude is that it isn’t dynamic. There are other points that effect valuation such as geopolitical uncertainty and future growth expectations, so saying its expensive when it gets over 20 is simplistic.

The penultimate signpost is the VIX increasing over 20 in the 3 months before the bear market. This indicator has been going since 1986 and also has a 100% hit rate. Usually having a close above 20 is common. The chart below reviews the average daily VIX close by year since 1986 and also the trading range in each year. As you can see, about half of the years have an average price above 20, meaning this indicator gives off many false warning signs. As you can see from the chart, the average VIX was 11.10 in 2017, making it the lowest average ever. We’ve already discussed how 17.28 was the lowest max ever. The only question was if that would hold up; it has. This trigger threshold is way above where the VIX is now since it’s at 10.18. It’s possible a 5% correction in stocks occurs, which pushes the VIX above 20. That would trigger 2 of the signals at once making 13 of the 19 warning signs wave a red flag.

The final signpost of a potential bear market is the ERR rule. I’m not 100% sure what this rule implies other than if the equity earnings get revised lower by a certain amount this indicator is triggered. It has a 100% hit rate since 1986 and is triggered now.

Amazing Year Ends Overbought

If you take into account the low volatility and high returns this year, it was one of the best ever. The Sharpe ratio is above 5, putting it in the 99th percentile for risk adjusted returns since 1926. While the market had a great year, this doesn’t mean 2018 will also be great. In fact, there could be a correction as early as January because the market is so overbought. According to the CNN Fear and Greed index the S&P 500 is at a 62/100 which is considered greed. The charts below are more disconcerting. As you can see, the 100 day RSI, the 200 day moving average, and the MACD 50 day divided by the 200 day daily moving average are all at their record highs. This overbought market could selloff in January even if no bad news comes out.

Conclusion

It’s quite something to see stocks have the best risk adjusted return year since 1926 while valuations are high and the Fed tightens rates. Don’t be fooled by recency bias into thinking that stocks have entered a new phase where they don’t move. If bitcoin and the alt coins have sucked the volatility out of stocks, they can easily put it back in stocks if they crash next year and traders lose interest in them. With their exponential returns, that’s quite a reasonable expectation.

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1 Comment

  • Ron W

    December 30, 2017

    All very well put- I think I almost understand what u put forth. Wld u pls combine all 20 in one message for this 'not smarter than a 5th grader' to read... and re-read...
    A fan of urs from the LV money show days with T/S. RonW