Another S&P 500 Warning Sign Appears. How To Deal With It.

Here’s the story of the Shiller CAPE Ratio and the 3 bears…bear markets, that is

As the stock market continues near new all-time highs, there are 2 questions investors should be asking themselves. * How high can it go? * How low can it go? Naturally, no one knows the answer to that. And by the way, if you do find someone who does, run the other way. They’re lying. However, that does not mean we can’t try to size up the 2-way potential for the S&P 500. This is major focus of my analytical work, as it leads toward positioning portfolios. It is one of many parts of the “risk-management” equation. That, in turn, can be translated into specific strategy and actions for a particular investor’s objectives and tolerance for volatility. That, succinctly, is what the investment process is all about.

Lightning alarm

Out where I live in South Florida, when the lightning alarm goes off and you are outside, you get to a safer area. The lightning might not get close enough to strike you, but you sure don’t want to be in its way if it does. As cautious as I am on today’s market conditions (my big picture Investment Climate Indicator has been on “Stormy,” its high-alert signal, since January of 2018. The stock market has been a loss-producing machine since that time.

Bull market? What are you calling a bull market?

The chart above shows that over the past 21 months, non-U.S. stock markets are down double-digits in percentage terms. U.S. stocks have done better, but small and midcap stocks are still down over that time. Only the S&P 500 is a winner from this list. And, the average stocks is up only 1.86%. That’s the purple line. The “winner” with a total gain of 5.24% in 21 months is the S&P 500 “cap-weighted” index, the line colored in sky blue. This paints a picture of an army that has lost many of its soldiers, and now the generals are in the enemy’s cross-hairs. The “market” is still going up in people’s view, even though much of the global equity scene has been somewhere between a draw and a loss for nearly 2 years. A small number of very large companies are keep the equity ship afloat. This may continue a while longer. In fact, I see technical evidence that offers potential for one more push higher in the near-term. However, this far into a bull market (its been more than 10 years), that may be all that’s left.

Professor Robert Shiller of Yale: a man with a CAPE

Now, for that warning sign alluded to in the title of this article. Simply put, a signal flashed back at the end of last year. It involves the “Shiller CAPE Ratio.” The CAPE is a version of the oft-used price-earning (P/E) ratio developed by Yale Professor Bob Shiller, who is one of the most frequently cited market commentators around. In reviewing the long-term history of the CAPE, I noticed a pattern. Major market declines in the past 50 years (those of more than 40%) have all occurred within a year or two of the 10-month moving average of the CAPE falling 10% from its high. In other words, a falling CAPE Ratio is part of every major bear market. Its a signal to pay attention. It is one of many I have cited over the past 2 years. As with any “moving average,” the idea is to filter out any temporarily wacky periods of time in market history. A moving average does that. There have been 3 such bear markets since the early 1970s, and the table below summarizes them. I also left a spot for the current market. Here is the order of things during those 3 bears (pardon the pun, Goldilocks).
  1. CAPE drops by 10% from its previous high
  2. S&P 500 value peaks
  3. S&P 500 drops 40-50%
  4. Most investors are angry
  5. Retirements are disrupted
The CAPE itself is widely-followed, and for good reason. However, I went a step further and looked at what happens some time after the CAPE peaks. You see, people have a habit of seeing a headline (like “CAPE hits new high”) and then going on to whatever hits their in box or social media feed next. Apparently, a high level of the CAPE is less significant than a decline from that high. That is, at least when that decline goes far enough. In this case, 10% lower is enough. This was essentially the alarm bell in the past 3 bear markets. It said “you still have time to get your financial possessions in order, but you had better do so soon.” You see, the “meat” of the past 3 bear markets occurred 1-2 years after the “CAPE down 10% from high” signal.

Today’s stock market

So, where are we today? We are 8 months past the peak in the CAPE’s 1o-month moving average. The CAPE itself ironically peaked in January, 2018. Recall that’s the same time my own internal indicator moved to “Stormy.” Now, I did not say that this CAPE-related signal I devised here automatically led to a market decline. There have been 10% declines in the 10-month moving average of the CAPE that did not “bust” a bull market and cause the S&P 500 to lose nearly half its value. There are false signals in every quantitative indicator.

The lightning alarm went off…don’t just stand there

Think of it this way: a falling CAPE does not mean a bear market. But, a falling CAPE has been a part of every bear market for the past 50 years. So, like many of the signals I have relayed to you since late 2017, here is another one that raises the specter of a difficult period ahead for stocks. And, this time could always be different. Heck, the S&P 500 was up more than 16% in the 8 months after the signal hit at the end of 2018. It has been a nice calendar year for stocks.

The S&P 500’s 2-way street

Remember, I said earlier that we should always be evaluating the market’s “2-way potential.” That is, how much likely upside and downside it has. There is always more possible upside. Bull markets die hard. However, I think the upside potential from here is dwarfed by the downside potential. That does not mean “sell everything,” but it does mean that anyone nearing or in retirement should know darn well what they own and why they own it. This is the same tune I have been singing (proverbially, not actually, since you do NOT want me to sing!) for 21 months. Until some things are resolved, stock market gains will require one to take on greater risk than at any time in the past 10 years. That’s why I incorporate hedging techniques like the ones I have covered in other articles recently. Keep a close eye on the many signals from market history that are creeping into the picture as we move forward. An all-time high in the S&P 500 is nice. But focusing on that point alone is a good way to invite the lightning to strike you.