THE STOCK MARKET ROBOT DASHBOARD
the equity gauge (price/money ratio)
Most investors rely on P/E ratio-based valuation indicators. Most investors underperform the market. The conclusion? The P/E ratio, although popular, intuitive and easy to use, is not particularly useful.
Earnings-based valuation measures have failed most investors since 2007. Trailing P/E signalled that the stock market was very expensive in Q1 2009. In fact, stocks were amazingly cheap then. Forward earnings estimates are notoriously unreliable and are mostly corrected downwards. The consensus of the analysts will betray you most bitterly when you need it most urgently.
What about CAPE (cyclically adjusted P/E) or Shiller’s P/E, which is supposed to smooth out short-term fluctuations in earnings data? Investors who followed CAPE are more likely to have underperformed than outperformed the market between 2009 and 2020. Why? CAPE methodology is systematically biased as it is based on flawed methodology. For many years CAPE has provided wrong “sell” signals.
The Equity Valuation Gauge is based on the price/money ratio. As the money supply in the economy grows, so do prices. The quantitative theory of money explains the relationship between the money supply and the consumer price inflation. The price/money model used here is based on similar logic.
It can be shown that asset prices (including major stock benchmarks) follow the growth of money in the long run. In the short-to-medium run, stocks may become undervalued or overvalued relative to the money supply. Unlike earnings, money supply is a very robust measure. This is particularly helpful under extreme conditions such as a financial crisis, a rapid post-crisis recovery or extremely low interest rates. (Remember, P/E fails miserably under such conditions.)
It is important to note that stocks can often continue to grow even if overvalued, or fall even when undervalued. The Equity Valuation Gauge value should not, therefore, be interpreted as a buy or sell signal per se. Other indicators are required in order to obtain the whole picture.
The Equity Gauge on 18 July 2007
The Equity Gauge on 17 July 2009
The Bank-O-Meter (or commercial banking activity indicator)
The Bank-O-Meter is a composite of two sub-indicators:
The Bank-O-Meter should be read as follows:
The Bank-O-Meter on 29 February 2008: Overheated
On 29 March 2009: Still overheated, but with a falling trend. A crucial difference!
The trend change makes the difference between the red and the green alert. While most macro figures look awful, the economy is already on the mend.
MONETARY THERMOMETER (THE MONETARY OVERHEATING INDICATOR)
In the old days of the gold standard, there was no Consumer Price Index. Inflation, however, was well known, although it meant something different then. It used to denote the growth of the money supply in the economy. Inflation as we know it today (consumer price inflation) was introduced only during the 1930s. The CPI methodology was thoroughly revised in the 1980s and 1990s. The revisions were so deep that the CPI has barely any meaning today.
Although overlooked by analysts and academia, monetary inflation has never lost its meaning and provides information on liquid money’s speed of growth in the economy.
Why is it useful?
Keeping track of monetary inflation is thus very useful for equity investors and economists. Oddly enough, this indicator tends to be overlooked by the mainstream. Inflation has become synonymous with the CPI, but monetary inflation has never lost its importance.
Monetary Thermometer on 28. June 1999: Overheated
When it comes to the detection of overheated markets, few indicators are better than monetary inflation.
On 4 October 2007: Once again overheated
profit/money ratio trend
In the long run, corporate profits grow at the same average pace as the money supply. The more money in the economy, the higher the profits. This is not really surprising.
In the short-to-medium term, corporate profit growth may substantially deviate from the average. During an expansion, profits grow much faster than the economy. During a recession, however, profits may fall well below the level that we might call an 'equilibrium'. When the recession ends, profits return to the mean level.
Note that you will not find this relationship in any textbook: The relationship between corporate profits and money supply has remained completely outside the interest of academia (as has the relationship between stock prices and money supply).
The Profitability gauge shows how corporate profits are deviating from their long-term trend. If corporate profits are, say, 30 per cent below the trend, then they will probably return to the mean sooner or later. Likewise, if profits rise too high, profit growth is unlikely to remain sustainable, leaving plenty of room for disappointment among investors somewhere down the road.
Because the relationship between money supply, stock prices and corporate profits has been largely ignored by the mainstream financial world, understanding it becomes very valuable. Anyone with an MBA or CFA, even the most junior analyst, knows numerous ratios: P/E, P/B, P/Sales, P/CashFlow, and so on. The Profit/Money (P/M) ratio provides information that is robust and rather unique, yet it is virtually unknown.
Profit/Money Ratio on 1 December 2006
A good news? High profits tend to revert to the mean trend, whereby creating a potential for future disappointment...
Profit/Money Ratio on 27 April 2009
... while depressed earnings have silver lining: the chance of returning back up to the trend level. Hence the green alert in the post-crisis market of April 2009.
risk level (volatility)
Risk Level is a measure of stock market volatility as expressed by the VIX index. This index is published daily by the Chicago Board Options Exchange (CBOE). Although it is based on a somewhat sophisticated set of calculations, its meaning is quite straightforward: The higher the number, the higher the perceived risk.
There is a snag, however. If Risk Level is very low, it is reasonable to expect that it will grow sooner or later. In other words, a low figure may signal the quiet before the storm. When the storm finally hits and stock prices fall in panic, Risk Level rapidly increases. When it reaches panic levels (over 30 or 40), it may be reasonable to expect it to fall, which usually means that stock prices find a level of stability and resume an upward trend.
When Risk Level falls from high levels, this is usually a favourable time to buy stocks. There are some caveats, of course: As the indicator merely displays the market perception of risk on a given day, not the true risk of the stock market itself, the Risk Level indicator should not be used as the only gauge of optimal time to buy or sell stocks.
Risk Level on 20 February 2007
Yes, that was a textbook case of silence before the storm.
Risk Level on 20 November 2008
Buy on panic... If you dare, that's it.
Yield Curve Spread (THE early-warning recession indicator)
The yield curve tells us the yield on bonds with varying times to maturity. In this particular case, the yield spread is simply the difference between the yield on 10-year US Treasury bonds and that on 2-year US Treasury bonds.
The yield on long-term bonds is usually greater than that on short-term bonds. This is the natural state of affairs, since long-term bonds are riskier. On rare occasions, however, short-term bonds may show higher yields. In such cases, we speak about an inverted yield curve.
When a situation like this takes place, an economic recession is highly likely to occur as soon as the yield curve spread starts to rise again. This has worked very well as a recession indicator in the US economy, at least during the post-war period. Since 1960, an inverted yield curve—where short-term rates are higher than long-term rates—has preceded all recessions. There was only one false alarm: In 1965.
Why does an inverted yield curve have such an uncanny ability to forecast a recession?
The yield curve reflects changes in market expectations of future short-term interest rates. A steepening yield curve—one with an increasing spread between long- and short-term rates—usually implies an expectation of higher short-term rates in the future. A flattening curve, on the other hand, implies an expectation of falling short-term rates.
Market expectations of future interest rates, in turn, reflect expectations of future real economic activity and monetary policy. During a recession, short-term rates fall as the demand for credit weakens and the Fed eases monetary policy. If investors anticipate a recession, they will expect short-term rates to tumble. This expectation can then translate into an inverted yield curve.
In other words, the yield curve reflects the collective expectations of the market, which is rarely wrong. The simple spread between long- and short-term interest rates has generally outperformed most forecasting tools as well as most economists in the commercial world and in academia.
The Yield Curve Spread on 8 December 2006
The US Federal Bonds yield spread went negative during the Winter of 2006/2007. Recession started only in December 2007 when the spread crossed the value of +0.5 p.c.
On 8. November 2007
As to forecasting recessions, the Yield Curve Spread tool is second to none: Proven in 2007 and once again in March 2020 when it called the recession 81 days earlier than the National Bureau for Economic Research.