No one saw it coming.
After most of the damage had been inflicted by the stock market crashes of 2000-2003 and 2007-2009, investment industry pundits and economists were equally at a loss to explain how anyone could have foreseen the epic crashes that unfolded. I don’t buy that. And after you digest this article, you probably won’t either. This article is going to educate the retail investor about some of the warning signs seen prior to the previous two major crashes. This is being done now because 2013 is (so far) resembling 2000 and 2007 in several ways.
Let me first offer this warning. These risk factors are prone to providing false alarms when used on their own. However, when taken in the aggregate, they paint a compelling picture. To be blunt, these risk factors suggest 2013 is much the same as 2007 and 2000: a topping-out year for the stock market that will precede an historic collapse.
Risk Factor 1: S&P500 P/E
Courtesy of www.multpl.com, attached is a chart of the adjusted P/E for the S&P500 index going back to 1881. These observations are inescapable:
- the P/E is mean reverting about a long term average of 16.4
- there are long cycles taking 35 years (or so)
- we’ve spent almost all of the past 26 years above (way above!) the long term mean.
As of today (March 27 2013), the adjusted P/E is above 23, more than 40% above its long term mean. Unless over 130 years of economic functioning has miraculously stopped because it is inconvenient for us in 2013, the P/E must continue down through the mean, to the same secular lows seen previously (in the 5, 6, 7 range). Hence a 65-70% collapse in the S&P500 over the next 1.5-2 years would align with the data from the previous 130+ years. Critics of relying on the adjusted P/E will rightfully point out that the P/E may remain above the long term mean for prolonged periods. That’s true. It certainly did in the late 1990s. But then again, look how that turned out.
In year 2000, the adjusted P/E set an all-time high of approximately 43. It would have been reasonable to expect an epic crash at some point. 2007 saw the P/E reach 27. Nowhere near 43, but still higher than almost any point in the previous century, and an understandable cause for concern.
Risk Factor 2: S&P500 Profit Margins
The attached chart shows profit margins for the S&P500 over the past 14+ years. It won’t surprise you that profit margins are also mean reverting. The long term average is 6.3%. Early in year 2000 and again early in 2007, S&P500 profit margins reached peaks, then began rolling over (mean reverting back down again). In order to make this point obvious, I have circled the peaks in profit margins and connected them to the lagging peaks in the stock market. The message is clear: anticipate profit margin compression for at least another year, and perhaps two as the mean-reverting trek continues. The stock market will be pulled down as it was in 2000-2003, and 2007-2009.
Risk Factor 3: Buying on Margin
The longer a stock market rally runs, the more investors become optimistic and use margin. This may be tracked by monitoring the amount of margin debt borrowed from brokerages. Shortly prior to the 2000 stock market peak, margin debt peaked at an all-time high. The same thing happened in 2007. It’s happening again now –the most recent data includes February. The chances are very good that either March or April will match or set a new all-time high for margin debt. Following the trend seen in 2000 and again in 2007, we might expect the stock market to peak in May.
Risk Factor 4: Insider Selling
Corporate insiders – the CEOs, CFOs, COOs and board members of publicly traded companies – frequently have a large portion of their net worth in company stock and stock options. Based on their privileged insider knowledge of a company’s prospects, elevated amounts of insider share sales may be interpreted as a sign of trouble ahead. Thus, executives take great pains to avoid selling significant portions of their shares. It is therefore reasonable to expect that when the pace of insider selling reaches a near panic state, it might be wise to do some selling of stocks in your own portfolio. To be clear, I’m not interested in large amounts of selling by an individual corporate insider, since that may be driven by personal circumstances. However, I am interested when the level of selling becomes exceptionally high from corporate insiders across the spectrum of all publicly traded companies. I don’t mean to disparage corporate insiders. However, I do believe it is justifiable to have an unflattering view of insiders when their publicly provided statements resemble comments like “the future is foggy” while they are quietly yet manically dumping their own shares. Frequently a few months before a recession arrives, corporate executives may be seen selling dramatically more shares than they’re buying. This was clearly evident in early 2007, and is once again this year. In fact, a new all-time high ratio of insider selling vs buying was seen in February when NYSE insiders sold over 10X the number of shares bought in 1 week. I don’t have complete data for 2000, so it is not presented. A graph of 2007 data and 2013 data is attached. 2013 data is estimated for this week and forward.
There are other risk factors that are of use in understanding stock market risk in a comprehensive manner. I use nine risk factors in a proprietary algorithm.