Wells Capital Management
Perspective
Economic and Market
Bringing you national and global economic trends for more than 30 years
August 31, 2016
Is the trend a friend?
U.S. stock market vs. post-war trend
James W. Paulsen, Ph.D
Chief Investment Strategist,
Wells Capital Management, Inc.
As the U.S. bull market completes its 90th month making
it one of the longest on record and rising by more than 3.2
times or annualizing at about 17% per annum, investors are
understandably becoming more and more concerned about
valuation risk. Indeed, many traditional valuation benchmarks
do suggest the stock market has become highly if not richly
priced. For example, the widely monitored Shiller CAPE priceearnings multiple rose to 27.3 in August, almost 50% above
its post-war average of 18.6 and higher than 91% of the time
since 1945. Similarly, on trailing 12-month earnings per share,
the current price-earnings multiple on the S&P 500 Stock Price
Index recently rose to 20.4, almost 30% above its post-war
average and higher than 85% of the time since WWII.
Undoubtedly, the potential left in this bull market is far less than
it was earlier in the recovery. However, despite already producing
the third largest percentage price gain among all bull markets in
U.S. history, many components of the contemporary stock market
either still remain below or have just now returned to post-war
trendline levels. Although traditional valuation parameters may
be flashing yellow, unconventional trendline analysis suggest the
stock market still looks reasonable if not attractively priced. It is
always useful to consider alternative thoughts and non-consensus
approaches in assessing important investment questions. To this
end, examining the U.S. stock market relative to its historic trend
yields several unconventional insights regarding both overall stock
market potential and also what investment factors (e.g., growth,
value, capitalization, or price momentum) and sectors may lead the
rest of this bull market.
Charts 1 and 2 illustrate the U.S. stock market relative to its
trendline since 1945. Chart 1 displays the popular S&P 500 stock
price index of large capitalization stocks. A broader measure
of the U.S. stock market including all stocks listed on the
NYSE, AMEX and NASDAQ exchanges is shown in Chart 2. In
both cases, the slope of the trendline represents the average
annualized gain in the index during the post-war era. The
“price” of the S&P 500 index has risen about 7.2% annually
during the post-war era and the annualized “total return” of the
broad stock index shown in Chart 2 has increased about 10.9%
per annum. Actually, both the S&P 500 index and the Total
U.S. Stock Index have performed similarly during the post-war
era since the average dividend yield on the S&P 500 index was
about 3.5% producing about a 10.7% annualized total return (i.e.,
a 7.2% price return plus a 3.5% income return).
As illustrated, U.S. stocks have oscillated about a stable trend
since WWII. To the extent this stable trend remains persistent,
it provides another methodology to judge potential risk and
reward in the stock market. Relative to trend, U.S. stocks have
been extraordinarily cheap three times since 1945 — immediately
after WWII, in the aftermath of the high inflation 1970s and again
after the Great 2008 crisis. Similarly, stocks appeared richly priced
throughout the 1960s and during much of the time between the
mid-1990s until the late-2000s.
Why has the U.S. stock market oscillated so consistently about a
steady trend in the post-war era? Because, as shown in Charts 3
and 4, annualized earnings growth (i.e., the primary stock market
fundamental) has also varied regularly about a stable trend of 6.5%
to 7%. While earnings and stock prices often diverge temporarily,
over the long pull, stock prices have been tethered to earnings
gains and as long as the primary equity fundamental moves closely
about a persistent trend, so will the stock market.
Economic and Market Perspective | August 31, 2016
Chart 1
Chart 2
S&P 500 Composite Stock Price Index*
Price index vs. post-war trend
Solid line — S&P 500 price index, natural log scale.
Dotted line — Slope of trendline is 7.2%, natural log scale.
Total U.S. stock market*
Total return index vs. post-war trendline
Solid line — Total return index of all NYSE, AMEX, and
NASDAQ stocks, natural log scale.
Dotted line — Slope of trendline is 10.9%, natural log scale.
Chart 3
Chart 4
S&P 500 composite trailing earnings per share*.
Earnings per share vs. post-war trendline.
Solid line — S&P 500 EPS, natural log scale.
Dotted line — Slope of trendline is 6.4%, natural log scale.
Total U.S. corporate profits with IVA and CCA*.
Total profits vs. post-war trendline.
Solid line — Total U.S. corporate profits, natural log scale.
Dotted line — Slope of trendline is 6.8%, natual log scale.
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Economic and Market Perspective | August 31, 2016
Stocks surprisingly appear reasonably-priced
or even cheap relative to post-war trend
Chart 5
Despite being one of the longest and strongest bull markets
of the post-war era, as shown in Charts 1 and 2, the U.S.
stock market is still at worst fairly priced and even cheap
relative to its post-war trendline. By comparison, the other
two major bull markets since WWII (i.e., during the 1950s-60s
and again in the 1980s-90s) both ended only after U.S. stocks
rose significantly above trend for several years.
Total U.S. stock market*.
Total Return Index as a percent above / below
post-war trendline.
*Total Return Index of all NYSE, AMEX and NASDAQ stocks
from French database as a percent of post-war trendline.
Charts 5 and 6 show the degree to which the U.S. stock market
is above or below its trendline. While a tripling of the stock
market since its bear market low in March 2009 argues that
this bull market must be in its late innings, both the S&P 500
index and the Total U.S. Stock Market remain below trend.
The overall S&P 500 index is currently trading about 3% below
trend while the broader-based total U.S. stock market remains
amazingly cheap at almost 25% below trend. Indeed, the total
U.S. stock market is currently priced comparably to the early1950s or the early-1980s. Perhaps equally important, even the
popular S&P 500 index is not nearly as richly-priced today as it
was in the 1960s or the 1990s.
Partly, stocks remain cheap today relative to trend because
the contemporary bull market began at such depressed
levels. For example, the current bull commenced in March
2009 when the S&P 500 index bottomed at about 677. Today,
the S&P 500 at 2180 is about 3.2 times higher than the bear
market low but only about 1.4 times above the previous
all-time record high in 2007 of 1576. By contrast, in the 1950s
bull market, by 1955, the S&P 500 was already about 3.1 times
above the previous all-time record high reached in 1946.
Likewise, by 1990, the S&P 500 was about 2.6 times above its
previous recovery record high established in 1981.
Chart 6
S&P 500 Composite Stock Price Index.
Price index as a percent above / below post-war trendline.
Although contemporary bull market gains have been
significant, much of its rise simply represents a “recovery” from
deep panic-induced losses in 2008-09. As shown in Charts 3
and 4, U.S. earnings fully recovered back to trendline early in
this recovery and as such the stock market simply reversed
what was mostly an overreaction to the Great 2008 panic.
That is, the second coming of the Great Depression never
happened, particularly in the earnings performance of U.S.
companies. Consequently, although the contemporary U.S.
stock market has risen by as much or more than most historic
bull markets, it still resides at a relatively attractive if not cheap
level relative to its post-war trend.
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Economic and Market Perspective | August 31, 2016
Chart 8
Charts 7, 8, 9 and 10 illustrate that relative to historic
trends, the U.S. stock market appears cheap across a wide
variety of investment styles. For example, large cap value
stocks (currently about 49% below trendline) are as cheap
today as almost any time in the post-war era. Small cap
growth stocks while less depressed are still almost 22%
below trend. Price momentum also remains extraordinarily
cheap, trading about 42% below its historic trend. Finally,
even the incredibly popular “high dividend stocks” remain
surprisingly cheap at about a 34% discount to trend.
Small cap growth stocks*.
Total Return Index vs. post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks
which reside in the lower half based on market capitalization
and possess a Market Capitalization to Book Value ratio which
is higher than 30% of all small stocks. The composition is
constructed in June of each year. Natural log scale.
Most traditional valuation guides suggest the stock market
is becoming stretched. Combined with a lengthy bull
market which has already achieved large gains, many
are turning more cautious towards the prospects and
risks currently facing stock investors. However, trendline
analysis challenges this current consensus view. Earnings
fundamentals continue to oscillate about post-war
trend levels while much of the U.S. stock market remains
remarkably cheap relative to its post-war trend.
Chart 7
Large cap value stocks*.
Total Return Index vs. post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks
which reside in the upper half based on market capitalization
and posess a market capitalization to book value ratio
which is lower than 30% of all large stocks. The composition
is constructed in June of each year. Natural log scale.
Chart 9
Strong momentum stocks*.
Total Return Index vs. post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks with
trailing price momentum which is among the strongest 30%
of all stocks. The composition is constructed each month.
Note: Data only goes to December 2015. Natural log scale.
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Economic and Market Perspective | August 31, 2016
Chart 10
outperformed so far this year, the discount shown by this
chart is probably no longer as pronounced. However,
surprisingly, despite their popularity, high dividend stocks
relative to low dividend stocks are probably at worst fairly
valued relative to the post-war trendline.
High dividend yield stocks*.
Total Return Index vs. post-war trendline.
Total Retun Index of all NYSE, AMEX and NASDAQ stocks with
a dividend yield which is among the highest 30% of all stocks.
The composition is constructed in June of each year.
Note: Data only goes to December 2015. Natural log scale.
Charts 13 and 14 illustrate that value has been persistently
dismissed in this recovery. It began overvalued, being favored
in the aftermath of the dramatic growth-led dot-com run, but
has cheapened considerably in this recovery. Indeed, among
either small or large cap stocks, value relative to growth is
about as cheap as anytime in the post-war era.
Chart 11
Small cap vs. large cap stocks — Relative Total Return
Index*. Percent above / below post-war trendline.
Total Retun Index of all NYSE, AMEX and NASDAQ stocks with
the 30% smallest market capitalizations relative to the stocks
with the 30% largest market capitalizations. The composition
of the two portfolios are constructed in June of each year.
Investment factor leadership
Trendline analysis also has implications for potential leadership
within the stock market. Charts 11 through 16 examine leadership
among four primary investment factors — capitalization,
dividend yield, value versus growth and price momentum. In
each case, the relative total return index (i.e., the ratio of the two
sides of each investment factor) is shown as a percent above
or below its respective post-war trendline. This data is from the
Kenneth R. French online database and includes all stocks on the
NYSE, AMEX and NASDAQ exchanges.
Chart 11 implies small cap stocks are currently as cheap relative to
large caps (i.e., currently trade at about a 20% discount to historic
trend) as anytime in the post-war period excluding the dot-com
era. The last data point on this chart was June 2016 and although
small cap stocks have outpaced in recent months, they are still
likely undervalued by post-war standards.
Chart 12 suggests, at least as of last year-end (note, the last
data point available on this chart was December 2015), that
the highest dividend yielding stocks within the U.S. stock
market were “undervalued” relative to the lowest dividend
yielders. Since the highest dividend stocks have significantly
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Economic and Market Perspective | August 31, 2016
Chart 12
Chart 13
High vs. low dividend yield stocks — Relative Total Return
Index*. Percent above / below post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks with
the 30% highest dividend yields relative to the stocks with
the 30% smallest dividend yield. The composition of the two
portfolios are constructed in June of each year.
Large cap value vs. growth stocks — Relative Total Return
Index*. Percent above / below post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks which
reside in the upper half in terms of market capitalization. Value
stocks are those which have a market cap to book ratio lower
than 30% of all large cap stocks and growth stocks are those
which have a market cap to book value ratio higher than 30%
of all large cap stocks. The composition of the two portfolios
are constructed in June of each year.
Finally, as shown in Charts 15 and 16, price momentum has been
a losing factor in the contemporary recovery especially among
small cap stocks. The collapse in the relative performance of
momentum was extremely severe after the dot-com peak and
was punished again during the 2008 collapse. Essentially, price
momentum has not regained leadership since the 2008 crisis.
Consequently, similar to value, the price momentum factor is
quite cheap today relative to its post-war trend.
Four sectors currently appear relatively expensive. Not
surprisingly, after outpacing throughout this recovery,
consumer discretionary stocks (Chart 17) appear the most
overpriced of any sector. Indeed, it currently is priced at one
of the largest premiums to trendline of the entire post-war
era. Also as expected, the two most economically defensive
sectors (utilities and consumer staples) currently trade at
significantly high premiums relative to historic norms. Rather
surprising, however, is the industrials sector (despite a near
manufacturing recession since 2014 and despite very weak
capital goods spending) appears expensive and has been
during most of this recovery.
Sector leadership
Finally, Charts 17 through 24 examine the trend relative
valuation of eight major sector stock price indexes. In all
cases, the sector total return indexes are relative to the overall
stock market and shown as a percent above or below their
respective post-war trendlines. Until 1990, these indexes were
formed from French’s industry total return indexes comprised
by all NYSE, AMAX and NASDAQ stocks. Since 1990, they are
the total returns of the S&P 500 sector indexes.
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Economic and Market Perspective | August 31, 2016
Chart 14
Chart 15
Small cap value vs. growth stocks — Relative Total Return
Index*. Percent above / below post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks which
reside in the lower half in terms of market capitalization.
Value stocks are those which have a market cap to book value
ratio lower than 30% of all small stocks and growth stocks are
those which have a market cap to book value ratio higher than
30% of all small cap stocks. The compostion of the two portfolios
are constructed in June of each year.
Strong vs. weak stock price momentum — Relative Total
Return Index*. Large capitalization stocks.
Percent above / below post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks among
the 30% largest capitalizations and with the 30% highest trailing
one-year returns relative to the stocks with the 30% lowest
trailing one-year returns. The composition of the two portfolios
are constructed each month.
Both technology (Chart 21) and health care (Chart 22) currently
are near historic trendline levels. It is interesting that in the
eighth year of this bull market, these two primarily traditional
growth sectors do not yet appear overpriced.
Finally, as expected, both financials and energy show
significant undervaluation. The energy sector (Chart 24)
is currently about 25% below trend, a level which has
represented a bottom for this sector several times outside of
the dot-com era. Meanwhile, financial stocks appear almost
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as undervalued today as they were overvalued in the mid2000s. They remain near a record post-war low relative to
trend. Oil stocks have bounced some since oil prices bottomed
earlier this year. Will financials finally close the gap relative to
trend if interest rates begin rising?
Economic and Market Perspective | August 31, 2016
Chart 17
Chart 16
Consumer discretionary sector stocks*. Relative Total
Return Index as a percent above / below post-war trendline.
*Prior to 1990, shops stock index from French database. S&P 500
Consumer Discretionary Sector Index thereafter. Higher values
suggest consumer discretionary stocks are overvalued relative to
the overall U.S. stock market. Last data point as of August 23, 2016.
Strong vs. weak stock price momentum — Relative Total
Return Index*. Small capitalization stocks.
Percent above / below post-war trendline.
Total Return Index of all NYSE, AMEX and NASDAQ stocks among
the 30% smallest capitalizations and with the 30% highest
trailing one-year returns relative to the stocks with the 30%
lowest trailing one-year returns. The composition of the two
portfolios are constructed each month.
Chart 19
Chart 18
Utilities sector stocks*. Relative Total Retun Index as a
percent above / below post-war trendline.
*Prior to 1990, utilities stock index from French database. S&P 500
utilities sector index thereafter.
Consumer staples sector stocks*. Relative Total Return
Index as a percent above / below post-war trendline.
*Prior to 1990, consumer non-durable goods industry stock index
from French database. S&P 500 consumer staples sector thereafter.
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Economic and Market Perspective | August 31, 2016
Chart 20
Chart 21
Industrials sector stocks*. Relative Total Return
Index as a percent above / below post-war trendline.
*Prior to 1990, 85% of manufacturing industry stock index and
15% of consumer durable goods stock index from French
database. S&P 500 industrials sector thereafter.
Technology sector stocks*. Relative Total Retun Index as a
percent above / below post-war trendline.
*Prior to 1990, business equipment stock index from
French database.
S&P 500 information technology sector index thereafter.
Chart 22
Chart 23
Health care sector stocks*. Relative Total Return
Index as a percent above / below post-war trendline.
*Prior to 1990, health stock index from French database. S&P 500
health care sector index thereafter.
Financials sector stocks*. Relative Total Return
Index as a percent above / below post-war trendline.
*Prior to 1990, money stock index from French database. S&P 500
financials sector index thereafter.
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Economic and Market Perspective | August 31, 2016
Chart 24
Second, the Total U.S. Stock Market Index (a much broader
index which includes all stocks on the NYSE, AMEX and
NASDAQ exchanges) currently trades almost 25% below its
post-war trendline making it cheaper than 78% of the time
since WWII (see Chart 6)!
Energy sector stocks*. Relative Total Return Index a
percent above / below post-war trendline.
*Prior to 1990, energy industry stock index from French
database. S&P 500 energy sector thereafter.
Third, many portions of the U.S. stock market remain
remarkably cheap relative to trendline including large cap value
stocks, small cap growth stocks, strong price momentum stocks
and even high dividend yield stocks (see Charts 7 through 10).
This certainly challenges conventional valuation parameters
suggesting most of the upside potential in this stock market has
already been fully achieved.
Summary and conclusions
Not surprisingly, after rising for more than seven years by
almost 220%, most traditional valuation gauges are warning
the bull market is getting old and the risk-reward profile of
the U.S. stock market is worsening. These indicators certainly
may prove legitimate and should not be ignored. Indeed, we
share concern for a stock market showing conventional signs of
becoming expensive and believe the potential left in this bull
market is far less than it was earlier in this recovery. However,
we believe investors should always remain open to alternative
thoughts and non-consensus approaches when assessing stock
market potential. Toward this end, it is particularly timely to
examine one such approach. Although traditional valuation
parameters may currently be flashing yellow, an unconventional
analysis based on the market’s historic trendline offers several
consensus-challenging implications.
First, while the S&P 500 currently sells at a fairly high 20
times trailing earnings, it also is about 3% below its post-war
trendline average. In both major previous bull market cycles
of the post-war era (during the 1950s-1960s and again in the
1980s-1990s), the S&P 500 Index ultimately peaked out at least
50% above trendline.
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Fourth, trendline analysis of four primary stock market factors
(i.e., market capitalization, high vs. low dividend yield, value
vs. growth and stock price momentum – see Charts 11 through
16) suggest risk-adverse fundamental factors have surprisingly
dominated the stock market so far in this bull market. This rather
odd result after a relatively long and strong bull market probably
reflects the odd “fear-based economic recovery” experienced
since the Great 2008 crisis. Conservative high dividend yield
stocks have outpaced low dividend stocks, more aggressive small
cap stocks have underperformed large caps, traditionally more
cyclical value stocks have trailed growth stocks and risk-on high
price momentum stocks have performed poorly. Consequently,
relative to their respective historic trends, current valuations favor
overweighting “risk-on factors” despite the fact this is already an
old bull market by calendar standards.
Finally, historic trendline analysis of sector performance yields
some expected conclusions and some surprising insights (see
Charts 17 through 24). As widely perceived, relative to postwar trends, defensive consumer equities including consumer
discretionary, consumer staples and utilities appear to be the
most overvalued sectors in the stock market. Surprisingly,
however, the industrials sector (despite a recent manufacturing
recession and lack of any real capital goods cycle in this
recovery) is also richly priced relative to post-war trendline
norms. The two stereotypical primary growth sectors —
technology and health care — are both near trend or fairly
valued. Lastly, as most fundamental valuation techniques
suggest, trendline analysis confirms that both the energy sector
and financials remain extremely cheap.
Since WWII, corporate earnings and the U.S. stock market have
risen persistently about a 6.5 annualized growth trend. Although
earnings are currently slightly below trend, they have returned to
and are again oscillating about the post-war experience.
Economic and Market Perspective | August 31, 2016
By contrast, however, the U.S. stock market remains significantly
below its post-war trend. We are not suggesting investors
discount traditional valuation indicators in favor of trendline
implications. Nor do we suggest the upside potential portrayed
by trend analysis should be ignored. This is an old bull market by
calendar standards and one which is becoming stretched relative
to conventional valuation methodologies. However, it is also a
stock market, which due to outsized fears reflecting a cultural
obsession with the potential for a second U.S. depression, is
currently priced remarkably cheap relative to post-war norms.
Should investors increasingly respond to traditional valuation
warning signs or should they remain mostly sanguine about
portfolio positioning in line with the potential yet suggested
by trend analysis? Who knows? Maybe both will prove correct.
Perhaps the current high traditional valuation profile will
keep stocks from surging as much as suggested by current
trend analysis. However, at the same time, maybe the bull
market will persist much longer than traditional values imply
and simply remain richly priced while delivering modest but
prolonged positive returns.
Written by James W. Paulsen, Ph.D.
An investment management industry professional since 1983, Jim is
nationally recognized for his views on the economy and frequently
appears on several CNBC and Bloomberg Television programs, including
regular appearances as a guest host on CNBC. BusinessWeek named him
Top Economic Forecaster, and BondWeek twice named him Interest Rate
Forecaster of the Year. For more than 30 years, Jim has published his
own commentary assessing economic and market trends through his
newsletter, Economic and Market Perspective, which was named one of
“101 Things Every Investor Should Know” by Money magazine.
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