10 Out of 13 Times, It Ended Badly – David Rosenberg

“Big money is made in the stock market by being on the right side of the major moves. The idea is to get in harmony with the market. It’s suicidal to fight trends. They have a higher probability of continuing than not.”

Martin Zweig

At the beginning of each month I like to take a look at the most recent published equity market valuations.  So let’s do that today.  As you review the charts, keep in the back of your mind that valuation metrics are pretty much useless in identifying market peaks but they are outstanding at helping us zero in on what the forward 10-year returns are likely to be.

You’ll also see that not only are the returns highest when the market is attractively priced, there is less risk.  The opposite is true when it is richly priced as is the case today.  But I’m a trend guy and the trend remains strong, so let’s be happy.

I’ve shared a number of intro quotes over the last few weeks about the Fed.  Do you remember Edson Gould?  He was a legendary technical analyst from the 1930s through the 1970s and developed a simple rule about Federal Reserve policy that has an excellent record of foretelling a stock market decline.

The rule states that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements or reserve requirements three consecutive times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback” (Schade, 2004). This simple rule is still relevant. Although it tends to lead a market top, it is something that should not be disregarded.

In the mid-1980s the great Marty Zweig wrote a book titled Winning on Wall Street.  He is quoted, “Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate – primarily the trend in interest rates and Federal Reserve policy – is the dominant factor in determining the stock market’s major direction.”

Zweig’s Fed policy rule is simple, “three steps and a stumble.”  Basically, when the Fed raises interest rates three times, the stock market stumbles.  When they lower rates, it’s good for stocks.

And just to hit on the Fed topic one last time, keep this from Stan Druckenmiller front of mind, “Earnings don’t move the overall market; it’s the Federal Reserve Board… focus on the central banks and focus on the movement of liquidity… most people in the market are looking for earnings and conventional measures.  It’s liquidity that moves markets.”

Expectations are for the Fed to raise rates again in March.  It will be step three.  As you view the valuation charts that follow, let’s keep a close eye on trend following indicators and a close eye on the Fed.

Grab a coffee and find that favorite chair.  I’ll story through each of the charts for you.

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Included in this week’s On My Radar:

  • Charts of the Week: Valuations and Subsequent 10-Year Returns
  • Equity Market Trend Evidence Remains Positive
  • 10 Out of 13 Times, It Ended Badly – Rosenberg on Fed Hikes and Recessions
  • Trade Signals – Zweig Bond Model Turns Bullish on Bonds

Charts of the Week: Valuations and Subsequent 10-Year Returns

Chart 1: Median PE


Several bullet points on Median PE:

  • The large red arrow points to Median Fair Value.  It is based on a 53 year Median PE of 17.
  • We are currently sitting 30% above that level.
  • Also, the market is considered 8.5% overvalued.   Overvalued and undervalued are determined by a 1 standard deviation move above and below Median Fair Value.
  • Note too that the small red arrow points to the current Median PE level.  It is higher than it was in 2007.  The only higher period was around the Tech bubble.

Chart 2:  10-year Forward Returns Based on Median PE

NDR sorted month-end Median PE readings into five quintiles.

  • Quintile 1 Lowest 20% of all PEs (most attractively priced)
  • Quintile 5 Highest 20% of all PEs (least attractively priced)
  • Data period is 1926 through 2014
  • Next shows the subsequent 10-year median annualized returns by quintile


In short conclusion, just like hamburgers, when you can buy them at a good price, you get a lot more for your money.  When they are expensively priced, you get less for your money.

Median PE is at 24.2 at January 2017 month end.  We sit solidly in quintile 5.  A median annualized return of 4.3% is closer to 2.20% after inflation (assuming 2% inflation).  Latest year-over-year CPI inflation is running at 2.50%.  The hamburgers are very expensive.

Here is what the quintile breakdown looks like from 1981 to present, just to give you a feel.


As a quick aside, I favor Median PE because it takes a lot of accounting gimmickry out of the mix (takes out all the highs and lows).  From there NDR looks at the subsequent return from each month end and sorts by quintile.  Really cool work.

Chart 3: Median PE – Select Dates

To make this a little more real, I selected several dates to give you an idea as to what the Median PE was then and what the subsequent annualized 10-year return turned out to be.

  • Green is low PE high return
  • Red is high PE low subsequent returns


Chart 4: Median PE – Highest and lowest returns by quintile

To be fair, it is possible that a return might come in higher or lower than the median.  To that end, here’s the nominal return data from 1981 to present:

  • Bar chart for the subsequent 10-year annualized returns (Median returns)
  • Bottom section shows the high low range.  Meaning there were over 300 total month-end readings with subsequent 10-year results.
  • Break that 300 down into five categories and you get 60 total occurrences.
  • The highest return and lowest return out of the 60 in each quintile is posted.  For example, in the best valued quintile 1, the highest return was 18.8% and the lowest return was 12.4%.  A 6.4% low to high difference. I’d be happy with both or that average.
  • However, note that the range begins to widen as valuations get more richly priced.  I’d be happy with that 9.8% best of 60 occurrences in quintile 5 but that is a low probability.


The overall idea is that we can get a highly probable feel for what forward returns are likely to be based on valuations.

The same conclusions are found if you look at Shiller PE or most other valuation measures.  Your money just can’t buy as much hamburger when it is expensively priced – not as much bang for your buck.

Chart 5: Market Valuation, Inflation and Treasury Yields: Clues from the Past by Jill Mislinski, 3/2/17

Below is some great