Are U.S. Stocks “Scared Enough” Yet?

I want to make a few points briefly. 

First, if you haven’t, please read Dr. Davis’ discussion of our economic data two posts below this (or click HERE).  He documents that economic times remain difficult, in line with the Gallup.com polling data I have frequently referred to.  He also points out how difficult it is to truly understand swings in economic momentum until long after the data has occurred.

Second, we have real-time market data to assist us.  It’s one thing for the Street to put stocks on sale for a while within an uptrend.  It’s another when, quietly, it turns out that the Russell 2000 index is down a large 10% year-on-year.  Also, its ETF (“IWM”) has begun under-performing the S&P 500 index the past year.  The last time this happened was in the lead-in to and early stages of the Great Recession.  Here’s a link to the 1-year comparison; please also click on the “max” tab and the 5-year tabs to see the relative trends.

Third, we have comments by informed observers.  From the Chicago PMI release this morning we found the following comment in the intro to the data dump:

The short term trend of the Chicago Business Barometer, and all seven Business Activity indexes, declined in May.  The Production index fell to neutral while, inexplicably, measures of Business Policy advanced.  (Emph. added)

Fourth, and tying in to the above, it simply appears to me that there has been more optimism than is justified by the actual economic data.  Wishing and hoping for the best is different from seeing it actually occur.  Sometimes markets get out of balance from their fundamentals, and the realignment of the one with the other can be sudden and involve a discontinuous price change.  This may be one of these times.  (I discussed this theme a bit more in my trading blog today and earlier in the week; LINK and LINK.)

Fifth and last, stocks are well above where both q and CAPE place them on the basis of their averages since the 20th Century dawned.  This periods encompassed at least one prolonged very low-interest rate environment.  Rates are low across multiple classes of borrowers for several reasons, one of which is as follows.  Providers of money to lend (“creditors”) see so few good investment opportunities in their own homes and communities that they are willing to lend at low interest rates rather than put their money under the proverbial mattress.  These sorts of times do not necessarily presage strong profitability for listed corporations.  More data on q and CAPE can be found at the Smithers website, link HERE (also click on associated tab, US CAPE and q chart).

Putting it all together, US stocks are arguably somewhat where global stocks were by mid-2008 or into the third quarter:  richly valued and ready to, perhaps hit the skids due to a spreading shock from a major economic center.  Four years ago the U.S. was the epicenter, now it is Europe.  Remember, it tends to take an established recession (Europe, not the U.S.) to occasionally cause a disaster before the business, political and monetary authorities can deal with it.  That’s what happened to the U.S. in Q3 of 2008, with well-known global effects. 

These comments are not predicting the end of the world as we know it.  They have nothing to do with short-term timing matters.  But I think there’s a bit too much insouciance in some parts of the American investment community about the downside potential from the European economic and financial situation when combined with what appears to be a below-trend economic expansion in the United States.  I will feel more confident about having seen a bottom in the stock market if and when the VIX and its sibling, the VXO, get above 30, which would tend to indicate that a lot of fear has re-entered the U.S. stock market.  I’m not hoping for this, but till then, I’m concerned that my fellow investors are not quite concerned enough!