The S&P 500 closing last week at a brand new all-time high means there is no shortage of “gurus,” bloggers, and media types calling for anything from a pullback to an outright crash in U.S. equities. The rationales that get attached to these claims never cease to amaze me. This time, the primary catalyst being blamed for the anticipated downdraft is “valuation.” This calamity story is another reminder of why it’s critical to be data dependent and process driven in financial markets.
Let me be clear that I’m not one of the many perma-bull U.S. equity cheerleaders who believes it’s always a good time to invest in the S&P. Rather, I’m perma-agnostic, and I let the data and my gravitational framework tell me when it’s time to be bullish, bearish, or completely out of a given market.
For instance, I carried a bearish bias on the S&P from August 2015 to September 2016 after carrying a LONG or NEUTRAL bias for 138 of the prior 141 weeks.
I’ve been LONG the S&P 500 since last September, and right now both the data and the framework are saying there is only one way to continue to trade the S&P: from the LONG side.
If there is one thing people love to chirp about, it’s valuation, and there has been no shortage of bandwidth used to tout how overvalued U.S. stocks are right now.
The problem with this valuation argument is that stock markets don’t correct or experience significant drawdowns because of valuation. People don’t wake up one morning and suddenly decide that 26x earnings is too much to pay for the S&P 500.
Here I pause to make a request to Buffett disciples who make the pilgrimage to Omaha every year to kiss the ring, and spend their weekends sifting through company balance sheets looking for the diamond in the rough: please keep nasty emails and passive-aggressive tweets to yourself.
I’m not implying that valuation as a metric isn’t useful as part of certain investing strategies. What I am saying is that using valuation as a metric to decide when the stock market is ready for a correction is like using the Super Bowl to determine the future direction of the stock market.
Back in the 1970s, Leonard Koppett figured out that the Super Bowl winner could accurately predict the future direction of the S&P 500.
If the AFC team won, the S&P would lose ground over the next 12 months, but if the NFC team won, then the S&P would gain in the following year.
At the time Koppett discovered this “connection,” the Super Bowl had accurately predicted the S&P direction 100% of the time. As of last year, this predictor of S&P returns has been right 40 out of 50 years — an 80% success rate!
Clearly, the Super Bowl has no real connection to the S&P 500; this is just a coincidence. In a similar way, stock market valuation has no real connection to causing corrections.