Prominent financial commentator: Three key indicators show that the rebound of US stocks is "foolish"

In recent weeks, the US stock market has seen a rebound, and the shadow of the sharp drop in early August seems to have dissipated. However, well-known financial commentator James Mackintosh believes that this rebound is very "foolish".

James Mackintosh used three key stock market valuation tools, cyclically adjusted price-to-earnings ratio (CAPE), forward price-to-earnings ratio (forward PE), and the Fed Model, to measure market valuations and concluded:

All of these indicators suggest that the valuation of large US stocks is uncomfortably high. Not only are they expensive relative to historical levels, but they also appear to be too high compared to small stocks, foreign stocks, corporate bonds, and government bonds.

If these measures are correct, then the recent rebound in the past few weeks may be foolish, and now is the time to stay away from large stocks.

Three indicators reflect at the same time: US stocks are too expensive!

Let's take a closer look at these three indicators:

Cyclically Adjusted Price-to-Earnings Ratio (CAPE)

CAPE divides the total market value of the stock market by the average earnings per share (EPS) of the past 10 years, providing a longer-term perspective on stock market valuation, proposed by Yale University professor Robert Shiller.

Currently, the CAPE value of the S&P 500 index is 35 times, the third highest since the 19th century, even higher than the peak in 1929. James stated that this indicates the extreme expensiveness of the S&P 500 index, especially the largest stocks.

Forward Price-to-Earnings Ratio (Forward PE)

Forward PE is a valuation indicator that evaluates the company's stock price relative to expected future earnings, calculated based on the estimated earnings per share (EPS) for the company's next year or longer period. It has been compiled by the IBES of the London Stock Exchange Group since 1985.

Similar to CAPE, the forward PE also indicates that stocks are extremely expensive, although slightly cheaper compared to 2000 or the end of 2020, the difference is not significant.

Fed Model

The Fed Model is a tool used to evaluate the valuation level of the stock market relative to the bond market, comparing the stock market's yield (usually the dividend yield) with the long-term government bond yield, proposed by strategist Ed Yardeni in the late 1990s.

Currently, this model also shows that stocks are very expensive. A month ago, before the significant drop in the 10-year Treasury yield, bond prices were even higher, and at that time, the price of the S&P 500 index relative to bonds reached the highest level since 2002.

Mackintosh affirmed the significance of these indicators, stating that when these indicators indicated that US stocks were overvalued, their returns over the next decade tended to be weak, and vice versa.

Since 1985, this pattern has usually held true, with CAPE and forward PE closely related to the S&P 500's returns over the next ten years, explaining about 85% of the return variation, while the correlation of the Fed Model is slightly weaker

Unfortunately, there is no perfect indicator. Long-term investment is not easy.

In the analysis above, some investors have suggested, "Then sell!"

However, Mackintosh points out that long-term investment is not that simple. Each indicator has its pros and cons, and these drawbacks have led to some bad investment decisions in the past.

For instance, CAPE reached its highest point since 1929 in July 1997. Shortly after, then-Fed Chairman Greenspan warned of an "irrational exuberance" in the market. However, since his speech, investors have seen an inflation-adjusted annualized return of 7%, outperforming the performance of the US stock market since 1900.

Even worse, CAPE has only been cheaper than its long-term average once since then. Despite the very effective buy signal in March 2009, investors using this indicator were unlikely to continue holding as the S&P index soared to so-called overvalued levels.

Analysis suggests that to bring CAPE back to its long-term average level, an unprecedented crash would be needed. A more likely explanation for the level of CAPE is that with mutual funds and ETFs making buying stocks easier and cheaper, wealth increasing, and real interest rates falling significantly since 1980, stock valuations have risen.

The drawback of forward P/E ratios is their reliance on analysts, mainly analysts from major banks. James points out:

"Long-term investors should be skeptical of anything based on Wall Street consensus."

Regarding the Fed model, which uses earnings forecasts from those same analysts, it has issued some truly wrong signals, such as in November 2007 suggesting that stocks were the cheapest relative to bonds since data began in 1985. However, the global financial crisis was looming, making it one of the worst times in history to buy stocks and sell US bonds.

James states:

While valuation tools have performed well over the past few decades, they may be products of specific market environments, and if the market environment changes, they may fail.

Furthermore, their effectiveness in other periods is not as significant, as their efficacy was exaggerated during the bad times from the dot-com bubble to the financial crisis