The Landscape

Valuation Compression

Awww, a good old correction. Nice to get that out of the way, so stocks are cheap again, right? Well, ummm.

There are two ways stocks can decline. Either the premium paid for X amount of earnings declines, or the amount of earnings themselves decline. In order for stocks to go down, one or both of those two things must happen. 

The Nasdaq declined over 30% from its peak, yet earnings are still rising. Therefore, we know that so far, we are seeing a valuation compression rather than an earnings compression. But here’s the thing—we are expecting an earnings compression as well, which is still to come.

Valuations have been compressing because professional money managers are selling. Retail traders, aka “the dumb money” are still buying. We suspect this correction or bear market won’t be over until the opposite is true. That is, until retail traders are dumping their positions into weakness while the professionals buy their positions at a discount. 

Retail traders tend to trade backward looking data. They love to buy things with a strong ten-year track record and avoid things that have underperformed. Unfortunately, that usually means they tend to buy high and sell low.

psychology-of-an-inexperienced-trader-2

So now that stocks have declined and their valuations have compressed, are they cheap by historical standards? Not by a long shot. By almost every measure that has predictive value, stocks are still overvalued, even for good corporate earnings results.

But, what happens if we add in a good old-fashioned recession? The way things are looking, its likely we will soon find out. Economic indicators are flashing warning signs and the Fed has promised to raise rates until something breaks. It is likely that something will break sooner rather than later because the economy is built on so much leveraged debt. The way things are, the economy is built on the dependence of continued growth to service the high debt levels.

Unfortunately for the market, nothing rises in a straight line. Earnings are no exception, and we will likely see earrings growth slow dramatically and probably reverse over the coming quarters.

Easy to understand charts that illustrate where our current valuation is relative to previous market bottoms is difficult to come by, but Mark Hulbert did a good job of illustrating current valuation vs valuations at previous market bottoms in this article in the Wall Street Journal. For those of you stuck behind paywall, the key takeaway is this—even at its lowest point in mid-May, the market wasn’t even close to being undervalued according to any of eight valuation models that his research shows have the best long-term track records.

Even a glance the chart above shows the decline to date is probably incomplete. If we are in a bear market, stocks still have a long way to decline, and a long time to get there compared to just the two big Bear markets that most of us experienced in our lifetimes. In short, buckle up, as this could take a while.

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