Is the market due for a correction?

November 6 2021

Unless we trade the S&P 500 ETF or something close to it, we cannot in the broadest sense say that we trade the market. We do trade the prices of individual stocks and more narrowly focused ETFs.

To get a sense of whether “the market” is vastly overpriced and due for a correction, I look at the data rather than listen to the usual pundits, TV talking heads, and fear-mongers.

The data I look at is actually various items like (1) Dividends vs Treasury Yield, (2) Forward PE vs TTM PE, (3) Price Targets upside from current prices, and so forth. I take the average of this data for all S&P 500 components and compare it over time.

All the data I look at is presented by the major broker-dealers and banks like JPM, Bank of America Merrill, Goldman Sachs, and Morgan Stanley, but I ignore those sources as they represent the sell-side and come with self-interested narratives. Instead, I do an independent study based on my own research methodologies and buy-side decision-making needs.

My conclusions are always rather general because, really, is the market ‘real’ anymore in terms of valuation-based price discovery, or is it merely something contrived by a network of politically connected heads of Humongous Bank & Broker and other big-money organizations opposed by factions seeking independence with their crypto purchases? In other words, there is no longer a natural, cyclical, price motion of markets and so a snapshot of the big picture is almost never going to be accurate and possibly not even close as to what’s going to play out in the following short-term.

As I have pointed out, a series of buys or sells of a few ETFs today, followed by the market prices directing impact of computer algorithms operated by big money market interventionists is sufficient to cause immediate chaos in the equity market.

Back to the data, I noted that in a recent study I did, the average dividend yield of an S&P 500 company was 2.80% (my records) at the time the competing 10-year US Treasury yield was 1.58. Today, with rising equity prices, the average dividend yield has fallen to 2.02% (again, my records) while the 10-year Treasuries are yielding 1.46%. The ‘Big Taper’ fear of course is that Treasury yield could rise to over 2% while the dividend yield at that time with further rises in equity prices could result in dividend yields falling well below that, which would lead to massive money exiting the equity market and moving into bonds. At this point, I don’t think there is much to fear.

Another factor I look at is the Relative Strength Index for the S&P 500 stocks, which today is a middling 57.6 average. Of the 500 components, there are 10 at super-high levels above 80, but that is just 2%. There are 71 above the warning level of 70, but that is just 14.2%. There are 218 above 60, and 151 between 50 and 60. Again, I don’t think there is too much to fear from these numbers.

A third factor I look at is the potential upside to the analyst price targets. Presently for the S&P 500, the average upside is +10.2%. The 1-year PTs are usually fantasy, but you might notice that for the stocks with the very highest RSI numbers, the latest price of the stock is actually above the PT, so as a top-down perspective, I think there are grounds to use this indicator as a measure of analysts’ content with market prices.

Finally, the guidance of these companies as to forward earnings is one that analysts pay close attention to and build into their assessments of the prospects of these companies. So, I like to compare actual PEs for the trailing 12 months to the forward PEs. What I see is an extremely high TTM PE, which has been widely reported and usually used by pundits and others as a sure-fire sign that the market is vastly over-priced and due for an extreme pullback. But the Forward PE is a fraction of that, and while still high on a traditional basis, the difference indicates the earnings growth that should be anticipated. I like to look forward – usually, six months is the conventional forward-looking period used by investors, but we are not living in normal times. The pandemic has impacted earnings like never seen in a hundred years or more. Meanwhile, our lifestyles and personal consumption have changed in a material way and investors have gone heavily into biotech, which has minimal to zero earnings. Money has been flowing into SPACs and start-ups that have no earnings. Greater volatility in markets has pushed investors into ETFs at a rate like not seen before, and many of these ETFs are participants in minimal or zero earnings disruptive technologies, which has pushed up equity prices and average PEs. So, these factors considered, I more heavily discount PE analysis in my studies.

I do a simple investment analysis that would best be done on a market-cap-weighted basis, but unfortunately, I don’t have the time. Besides, as noted, I am seeking only a general impression of the broad market that will skew my bias a bit when buying or selling individual stocks of the companies I invest in. Any deeper analysis would only lead to what I call the apple-polishing syndrome – you know, we can only polish an apple so much and it’s still the same looking apple, so the extra effort is a waste of time.

In summary, the market data is telling me that we should not fear a broad-market collapse in prices. So, I carry on as usual with something like 96% of funds invested except for specific circumstances.

Having said that, I do sell all or trim back substantially positions whenever I see day trading at two-standard deviations above the daily data rate.

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