Into the Swarm #4: Everything Is Relative and Only That Is Absolute
Last post before a short summer break.
Down the Market Hole
While equity markets have broken many records in terms of relative valuation, some people still argue that stocks are not that expensive.
Of course, everyone has heard about TINA and the idea that valuations remain attractive in a low interest rates environment. In my opinion, TINA is an intellectual fallacy (see Dear TINA, We Need to Talk).
Recently, I noticed that people were using another metric to try to justify current valuations, putting forward the so-called price-earnings to growth ratio (PEG). The argument is simple: the PEG is low on a historical basis, meaning that the market may be cheap from a growth perspective. In other words, the price-to-earnings ratio (PE) of the S&P 500 is elevated, but one should consider the growth potential of US companies’ earnings to relativize the level of the PE ratio.
A simple look at the PEG ratio (see Yardeni Research’s chart above) enables to confirm the fact that it is currently low and that it has been decreasing for weeks. But is that supposed to be a buy signal?
To answer that question, it is important to study the behavior of the PEG ratio over past periods. And that leads to counter-intuitive (though meaningful) conclusions.
While the 2007 peak of the PEG coincided with the top of the S&P 500, in 1999 the PEG started to decline months before the peak of 2000. 2018 was a tough year for US equity markets, and the PEG had already dropped since the end of 2017.
Conversely, the 2015 peak did not mean that a market rupture was coming. Nor did the peaks of end 1998 or end 2008. Actually, the fact that the PEG ratio is soaring may signal an imminent rally of equities.
In other words, a PEG ratio that rises could be treated as a positive sign for stocks, while a falling ratio should urge caution.
Why would it be counter-intuitive? When the PEG is rising, market prices are moving up faster than realized (or expected) growth, meaning that investors are anticipating higher earnings growth in the future. If fundamentals quickly confirm that optimistic scenario, then participants will keep on increasing their estimates, more investors will join the party and a bull market will be formed.
Imagine now that a few years later, earnings growth have filled in the gaps, and that some investors anticipate that fundamentals have reached an inflexion point. Such a situation leads to profit taking and a decreasing PEG ratio. As soon as the rest of the market realize that earnings growth has peaked, equities enter bear market.
What about now?
The S&P 500 PEG ratio peaked around June 2020. Despite a flash rebound at the beginning of 2021, the ratio has almost crashed since mid-2020, meaning that earnings growth may be close to its peak.
While some strategists argue that this is a positive sign, historical analysis tells us a dramatically different story.
Red Queens Narratives
Beyond the PEG ratio, there has been an accumulation of bearish signals for the past weeks. Of course, many participants do not pay attention to that, as bears are assumed to be “idiots” (this is the new market paradigm).
But people may have noticed bearish divergences on US large cap indices from a long-term perspective, as well as very low trading volumes, negative internals, compressed volatility, a rising SKEW index, hyper-concentration (everyone loves the FAANGs right?), lower liquidity, and extreme risk-on positioning in the system. In other words, the level of complacency has never been so worrying.
Moreover, if Zoltan Pozsar is right, then we might get another bank liquidity crisis soon (please stop sending GIFs from Dude, Where’s My Car, I think everyone got the joke).
Last but not least, yields are suggesting that the economy is about to reverse. There are many factors which can explain that: slow vaccination rates in many parts of the world, new infectious waves catalyzed by variants, negative effects of economic distortions caused by Western central banks, etc.
Like it or not but the bond market is almost always right when it comes to the macro picture.
But of course, it is not when the avalanche begins that one should start thinking about thinking about buying protections.