Our pH Report sentiment Index has proved a reliable guide since its December launch. Most commentators then expected another year of strong performance in 2022. But the Index was rightly more cautious, as the chart confirms.
The Index typically gives a 3-month warning of future S&P movements. Thus it also forecast the recent rally in July/August. And it has correctly anticipated today’s further downturn.
The size and speed of the downturn is not a great surprise.
The surprise is really that central banks were allowed to spend the past 20 years effectively destroying price discovery in financial markets:
- Former US Federal Reserve Chairman, Alan Greenspan, began the process in the mid-1990s with his invention of what came to be known as the ’Greenspan put’
- This was a term derived from the Options market, and signified that the Fed would intervene to support markets if they began to break down
- After Greenspan left office, his concept became known as the ’Fed put’ and was applied on an increasingly regular basis after the subprime crisis
As Fed chairman, Ben Bernanke, described its purpose in 2010:
“Higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending.”
Now we are starting to see the downside of this process as markets rediscover their key role of price discovery. Unfortunately, this is unlikely to be quick or painless, as the asset bubbles created by central bank stimulus start to burst.
This assessment is confirmed by the long-term outlook provided by Nobel Prizewinner Prof Robert Shiller’s CAPE ratio. It is based on the average 10-year Cyclically Adjusted Price/Earnings ratio as the chart shows:
- This confirms that in CAPE terms, today’s market most closely resembles 1928-32 and 1998-2003
- It peaked in December at a CAPE ratio of 39, versus 33 in September 1929 and 44 in December 1999
This also suggests there is major downside, if the ratio now starts to return to its long-term averages:
- The 1881 – 2021 CAPE average ratio was 17; the post-War 1946 – 1995 average was similar at 15
- But the ’Fed put’ meant the 1996 – 2021 average was nearly double these levels at 28
- Similarly, the Earnings side of the ratio averaged 64 over the full period, but 73 in 1996-2021
This difference is significant if one wants to use CAPE history to consider possible end-points for the downturn, as the chart shows:
- It shows the continuing parallel between the S&P’s performance since its 3 January peak of 4797 (red line) and the post-September 1929 (blue) and December 1999 (green) peaks.
- These parallels would suggest that we could expect the downturn to finally “bottom” around 650 trading days from its peak
- We have so far seen 182 trading days since the top. So 650 days would suggest a bottom sometime in 2024
- But it also suggests there will be several more ‘bear market rallies’ (aka “bull-traps”) along the way, until it finally ends
We can also now start to estimate the S&P’s possible final bottom if the parallels continue:
- A return to its 1996 – 2021 average would imply a bottom at 2044 (CAPE ratio 28 x Earnings 73), equal to -57% on the chart
- This would be similar to the end of the 1998 – 2003 downturn.
- But a return to its long-term average would imply a bottom at 1088 (CAPE ratio 17 x Earnings 64), equal to -77% from the peak
- This would be similar to the end of the 1928 – 1932 downturn
Most commentators chose to ignore the warnings on inflation and recession provided by chemical industry data. As a result, they have been blindsided by the speed and scale of the S&P 500’s downturn. But the Sentiment Index has proved far more reliable.