The recent market volatility has led many investors to consider whether they are better off to stay on the sidelines. The stock market has exhibited wild daily swings, a sharp down day followed by a strong up day or vice versa, in recent months. On May 10, the day this article was written, the Dow Jones Index rose 223.46 points or 1.26% and Standard & Poor's 500 Index moved up 25.70 points for 1.25%, according to CNBC.
Investors are searching for possible answers and causes to justify the surprise upside move. In the following paragraphs, I utilize some charts to highlight the current market conditions that expose investors to an asymmetric risk. Investors may consider investing in individual stocks rather than the stock market as a whole. The current market risk characteristics encourage investors to be stock pickers rather than passively investing in the market.
Strong market volatility is typically observed at turning points before the market moves up to a new high or moves down to make a correction. Buyers seek to prove their bullish sentiments while sellers strive to prove them wrong. Often market volatility is due to lack of clear sentiment on market valuation. Market multiples or valuation ratios are among valuation methods that help investors determine relative valuation, invest in a security or sell an existing position.
Price to Earnings or P/E is a popular ratio used to ascertain whether the market is overbought or oversold. Earnings in the ratio are based on accounting profit, which takes into consideration explicit costs only as opposed to economic profit, which considers implicit costs. Per generally accepted accounting principles (GAAP), reported earnings, net income after taxes, could be manipulated due to the earnings management by CEOs.
Management is motivated or pressured to be WISE to use any of the following tools to manage the earnings: Window Dressing, Internal Targets, Income Smoothing and External Expectations. In other words, management can manipulate financial statements for better executive compensation, to meet established performance expectations and maximize personal compensation. Accrual accounting principles like inventory costing system and depreciation methods are among the accounting principles that allow subjective estimate and judgment calls to influence earnings.
Figure 1 - Historical S&P Index Earnings Yield (Data source: multpl.com)
Converting P/E to E/P, which is the earnings yield, allows analysts to study the current market condition and compare it with other types of yields' historical performances. The Earnings Yield (E/P) for the S&P index has been going down as depicted in Figure 1. Utilizing the published data to generate Earnings Yield for the S&P Index, the highest yield recorded was on Dec. 31, 1917 for 17.48%, then lower highs in 1948 at 15.11% and 1979 at 13.53%.
Since then, it has been dropping and registered at 4.2% on May 9. The 10-year Moving Average, a technical indicator to smooth the data points, does not depict a positive view either. As shown in Figure 1, the Earnings Yield is below the moving average, which is a bearish reading signaling further downward move. In fact, since 2011, the market has experienced an "earnings recession," as each year the earnings have fallen below the prior year.
Surprisingly, the earnings recession has occurred in light of a low cost of capital, which provides the opportunities for companies to borrow at historical low interest rates for capital expenditures and expansion for better earnings.
Figure 2 - Historical charts for S&P Index Earnings Yield and Dividends Yield. (Data source: multpl.com)
Comparing earnings yield with the dividend yield for the S&P Index should shed more light on the earnings weakness. According to the data retrieved from multpl.com, dividend yields have had a downtrend move as well since its historical high in 1917 at 10.15% and a lower high for 9.72% in 1931. However, for the past 20 years, the dividend yield for the index has been around 2% or so with an estimated reading for 2.13% on May 9.
As illustrated in Figure 2, the spread between Earnings Yield and Dividend Yield is about 1.97%. Considering the dividend-paying stocks is a main asset in q fixed income portfolio, to have a low spread indicates investors for common stocks are taking more risk without proper compensation. In other words, investors are exposed to an asymmetric risk by investing in the stock market.
Figure 3 - The annual spread between earnings yield and dividend yield for the S&P Index since 1900. (Data source: multpl.com)
Figure 3 depicts the historical annual spread between earnings yield and dividend yield as it made a double top chart formation between 2006, 2011, and now dipping under the 10-year moving average. Technical analysts consider the chart pattern as a bearish signal, which signals a further narrower spread between the two yields. This confirms the earlier assertion that the stock market has become riskier due to its asymmetric risk exposure.
Additionally, the dividend yield narrative does not support a strong bull market. Consider Figure 4, which portrays the historical dividends yields for the S&P index with a 10-year moving average. The dividend yield is kissing the moving average with a potential upward move. An increase in dividend yield indicates the bearishness of the market, since companies need to offer higher dividends to entice investors. It could also signal lower price for the stocks.
Figure 4 - Historical Dividend Yield for S&P 500 Index with a 10-period Moving Average. (Data source: multpl.com)
Price to Sales (P/S) and Price to Book Value (P/B) are two additional market multiples for stock valuation. If earnings is exposed to management discretion and manipulation, there is less chance for sales and book value to be managed. Observing the historical charts for P/S and P/B could reveal some valuable information on the current stock market's brittle condition.
Consider Figure 5, which shows the historical charts for P/S and P/B dating back to 1999. According to the data retrieved from multpl.com, since 2009, both charts have been edging up, which indicates higher price or lower sales and book value. The estimated reading for P/S at 1.83 on May 9 is higher than 1.77 measured for Dec. 31, 2000. However, P/B is almost at the same level as it was in 2002. Accordingly, the 15-year readings on P/S and P/B signal a bearish outlook for the stock market.
Figure 5 - Historical P/S and P/B for S&P 500 Index from 1999 to 2016. (Data source: multpl.com)
In light of the current low interest rates and availability of capital at historical low cost, companies may continue to borrow funds to pay dividends and repurchase shares. However, if the current credit expansion is disrupted as the Fed continues to increase the interest rates, companies may have a hard time repurchasing stocks for a further price surge. This in turn poses more risk to the stock market. In other words, investing in the stock market poses asymmetric risk to investors. Therefore, it may be time to consider investing in stocks rather than the stock market.
Disclaimer:Â Dr. Ned Gandevani is a graduate finance professor at Harvard University and New England College of Business. He is a published author with four books and many articles in investment, finance, business, investment psychology, and accounting topics. He could be reached at [email protected] or 617-910-6256.
Gandevani is an Investment Advisor Representative (IAR) of NMG Capital Group Inc. of Boston. Securities products/services and advisory services are offered through NMG Capital Group Inc., a registered investment advisor. This article is for general education purposes only and does not, nor is it intended to, constitute legal, tax, investment or financial advice. Please consult with your attorney, accountant and/or tax advisor concerning your particular circumstances.
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