Here's what S&P500 has done over last 2 years 4 months:
S&P500 has traded in a range between 1810 and 2125
There are two observations one can make based on the above chart:
- Everytime S&P500 declines near 1810-1840: there is very strong buying that takes place
- S&P500 does not sell off near highs but it trades sideways. It means there is no fear at the top.
What does the price action indicate?
Despite excessive pessimism - the S&P500 continues to trade with strength and more inclined to go higher. Market Tops are not formed by bad news. It is when the market starts selling on good news - then one should get worried and take notice of the market. As of now, the market is rallying on bad news.
Buy Back Bull Market
It's like when history will be written, this bull market will go down as Buy Back Bull Market.
US companies have bought back shares worth $2.47 trillion dollar in last 5 years. That explains the relentless bull market
— Deepak Singh (@smarket) June 23, 2016
In last 12 months - US companies have bought back shares worth $589 bn. Buy Back reduces the number of outstanding shares and boost EPS and makes PE attractive.
What about Valuations?
The current 12 month forward PE (Price to Earnings) ratio is 16.4. This is high compared to average of 14.3x. Now remember, PE ratio as a standalone tool counts for nothing. Stocks are considered undervalued as long as Earnings Yield > Treasury Yield. [Earnings Yield is inverse of PE]
Is stock market overvalued or bond market overvalued?
Earnings Yield right now is 4.3%..
10 Yr Treasury yield is 1.56%
— Deepak Singh (@smarket) June 17, 2016
PE is best Perception of market on how to value company's earnings. In a low interest rate environment, stocks tend to be overvalued because there is TINA (There is No Alternative) factor at play.
In a low interest low inflationary environment - stocks are considered to be an attractive asset because they yield more than treasury yield. Also, Corporates are buying back stocks at record pace and it's helping companies compensate for low growth.
Bullish Behaviour: Market is rallying on Bad News
Warning sign to watch out for - When the market starts selling off on Good News.
There is a logic why S&P500 has sustained the strength all this while.
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Disclaimer – The state of the market notes is Deepak’s perspective on the market. The column is purely for educational purpose. Nothing contained herein is a solicitation to trade or a recommendation of a specific trade. By reading this publication you agree to make no trade relying in whole or in part on the comments of the writers