Saturday, 29 November 2014

The U.S. Stock Market Risk Indicator, November 2014

Just when a tempting thought crossed my mind that the downside risk to the U.S. stock market could not get much higher, a surging stock market in November sent the U.S. stock market risk indicator discussed here to a new all-time high. *

The higher the reading, the poorer the return prospects for stocks going forward. 

The indicator is constructed combining insights from both value investing and the Austrian school of economics. During the month, the indicator component based on value investing surpassed the previous high from May 2007 which peaked five months prior to the end of the previous bull market. 

The Austrian economics component remains among the top five percent highest ever reported, though it's now somewhat lower than it was a few months ago. A marginally higher personal savings ratio and a slowing decline in the growth rate of the money supply contributed to the slight contraction in this risk component during the past few months. 

The indicator is flashing red on all fronts suggesting the probability of poor future stock market returns has never been higher based on data going back to 1986. Furthermore, if the indicator works as well going forward as it did in 2000 and 2006/2007, it suggests that a significant stock market decline is highly likely for the U.S. stock market sometime in the not too distant future.

All my other stock market indicators are also flashing more red than they perhaps ever have. I have published some of those indicators here. In fact, I am struggling to find any indicator at all suggesting the stock market is a fair buy at current market valuations. There is one indicator, the spread between the earnings yield of the S&P 500 and the 10-year treasury yield, that does suggest the stock market is fairly priced, perhaps even undervalued. However, the spread is high due to artificially low interest rates and nothing else which in my view should be mainly interpreted as just another significant risk factor. 

The timing of a likely stock market peak, correction or outright crash hinges in my view on the money supply developments going forward. The quicker the growth rate declines, the quicker the correction will be brought about. If the growth rate expands however, the stock market could continue to rise with it. This report should therefore be read together with the money supply report published earlier today

Having said that, at such extreme market valuation levels any event, big or small, can quickly bring about an end to the required optimism necessary to sustain current market prices. Not to mention the debt problems in the U.S., large parts of the EU and Japan which will soon once again play a bigger role in the financial markets. 

Please note that I am short the U.S. stock market. 

* Regular readers of this monthly indicator should be aware that historical data are frequently revised by the data publisher which might affect the historical values of the indicator published in this report. Such revisions are usually marginal however and has little bearing on the indicator.

Suggested reading: 

Lessons Worth Remembering: Who Predicted the Bubble? Who Predicted the Crash?