The gauge on the left indicates whether the market is in a bull or bear phase, and the indicator on the right reflects the current valuation of the stock market. Stock market pricing indicates whether stocks are cheap or expensive in relation to earnings, but it is a poor indicator of market timing. We do not recommend selling stocks because market valuations are high; however, we recommend exercising caution when adding new positions.
Bull/Bear Market
The Bull/Bear indicator remains at 40%, warning of a bear market ahead, with three of five indicators signaling risk-off.
The Chicago Fed National Financial Conditions Index increased to -0.486 from -0.514 last week. Financial conditions are tightening, and a rise above -0.40 would signal risk-off.
Stock Pricing
Stock pricing eased to 92.37 percent from 94.60 percent last week. The steep change from 98.64 two weeks ago is partly attributable to a break in the series. We replaced the Price-to-Sales ratio and Forward Price-Earnings Ratio for the S&P 500 with similar series for the Dow Jones Industrial Index. However, there is one notable difference: we use a 20% trimmed mean, which excludes the top 10% and bottom 10% of readings for individual stocks, to minimize distortion from outliers in the smaller index population of 30 stocks. The reading remains extreme, warning of a significant drawdown in stocks.
We use z-scores to measure each indicator’s current position relative to its historical data, with results expressed in standard deviations from the mean. We then calculate an average of the five readings and convert that to a percentile. The higher the stock market price measure is relative to the historical mean, the greater the risk of a sharp drawdown.
Warren Buffett’s favored long-term measure of stock market value, the ratio of stock market capitalization to GDP, continues to warn of extreme valuations. The pull-back to 2.91 remains more than double the long-term mean of 1.20, indicating the potential for a large drawdown.
Conclusion
The bull-bear indicator at 40% warns of an impending bear market, while extreme price levels highlight the risk of a significant drawdown.
Acknowledgments
- Prof. Robert Shiller: CAPE 10 Data
- S&P Global: S&P 500 Sales and Earnings Estimates
- University of Michigan: Survey of Consumers
- Federal Reserve of St Louis: FRED Data
- Bureau for Economic Analysis: Motor Vehicles Data
Notes
- See Managing Risk to learn more.
- See Bull-Bear and Stock Valuation for more on our composite market indicators.
Colin Twiggs is a former investment banker with almost 40 years of experience in financial markets. He co-founded Incredible Charts and writes the popular Trading Diary and Patient Investor newsletters.
Using a top-down approach, Colin identifies key macro trends in the global economy before evaluating selected opportunities using a combination of fundamental and technical analysis.
Focusing on interest rates and financial market liquidity as primary drivers of the economic cycle, he warned of the 2008/2009 and 2020 bear markets well ahead of actual events.
He founded PVT Capital (AFSL No. 546090) in May 2023, which offers investment strategy and advice to wholesale clients.