Being a Stock-Market Bull Just Got a Lot Harder

question-markMy Comments: For over a year now, I’ve been warning my clients that a reversal is coming in the stock market. As a result, we’ve slowly moved into investments that have reacted positively and made money during downturns. Only it hasn’t happened yet.

Consequently, some of them are frustrated and angry with me because while the market has grown considerably in the last eighteen months, their accounts have not kept up, and look rather anemic.

Having been through this kind of thing before, and somehow survived, I continue to promote ideas that have made money for clients, especially 2007-2009 when the last crash happened. While I don’t expect the next one to be as big, it will still be painful. Unless…

By Mark Hurlburt – September 9, 2014

London (MarketWatch) — Making the bullish case is getting a lot harder.

Let’s say that you want to wriggle out from underneath the bearish conclusions of the cyclically adjusted price-to-earnings ratio (CAPE), which for some time now has been very bearish. Sidestepping that conclusion turns out to be a lot harder than you think.

The CAPE is the version of the traditional P/E ratio that has been championed by Yale University finance professor (and recent Nobel laureate) Robert Shiller. Currently, for example, the CAPE stands at 25.69, which is 55% higher than its average back to the late 1800s of 16.55 and 61% higher than the ratio’s median level of 15.95. In fact, there have been only three times since the 1880s when the CAPE has been higher than where it stands today: 1929, 2000 and 2007 — all three of which, of course, coincided with major market highs.

The CAPE isn’t a perfect indicator, as Shiller himself will tell you. There are legitimate reasons to question its approach to market valuation. In addition, the bulls have shamelessly come up with myriad other “reasons” not to pay attention to it.

But Mebane Faber, chief investment officer at Cambria Investment Management, has this to say to all these so-called CAPE haters: “Fine, don’t use it. Let’s substitute in book and cash flows, two totally different metrics.”

Unfortunately for the bulls, the conclusion of looking at the market from those alternate perspectives is almost identically bearish.

Courtesy of data from Ned Davis Research, Faber ranked 43 countries’ stock markets around the world according to their relative valuations according to the CAPE as well as to cyclically adjusted ratios of price-to-book, price-to-cash flow, and price-to-dividend. When ranked according to the CAPE, for example, with top ranking going to the most undervalued country’s stock market, the U.S. is in 41st place. Only two countries are more overvalued according to this indicator.

CAPE = 41
Cyclically-adjusted price-to-book ratio = 37
Cyclically-adjusted price-to-dividend ratio = 39
Cycilcally-adjusted price-to-cash-flows ratio = 36

To argue that the U.S. stock market isn’t overvalued, in other words, the bulls not only have to dismiss the CAPE but also argue why the U.S. market should be priced so richly relative to book value, cash flows and dividends.

That’s not necessarily impossible. But it is clear that the bulls have a lot more work cut out for them.

Furthermore, even if the bearish conclusions of these diverse indicators turn out to be right, you should know that they are long-term indicators, telling you very little about the market’s near-term direction. My favorite analogy to describe the situation comes from Ben Inker, co-head of the asset-allocation team at Boston-based money management firm GMO.

He likens the market to a leaf in a hurricane: “You have no idea where the leaf will be a minute or an hour from now,” he says. “But eventually gravity will win out and it will land on the ground.”