Although the S&P 500 is overvalued by P/E (current: 25.76, average: 15.63) and Shiller P/E (current: 27.9, average 16.7) measures, the market still has more upside according to the two economic indicators that I monitor, the Chemical Activity Barometer ( CAB ) and the Chicago Fed Financial Conditions Leverage Subindex. If overvaluation alone would cause a market crash, another crash would have happened at some point within the past three to five years. A trigger is needed to change the perception of the market participants. Two likely triggers have been shown to be economic recessions and overly tight financial conditions.
The CAB and leverage subindex were first brought to my attention by GuruFocus founder and CEO, Charlie Tian, during my time as the financial analyst. I have chosen to follow these indicators because of their reliability in predicting recessions and bear markets, and they have not triggered any false positives in the recent cycle such as many other indicators. Although there were two near bear market occurrences in 2011 and 2016, the markets quickly bounced back. Neither of these occurrences triggered any warning signs from the CAB and leverage subindex.
The latest CAB measurement was released on Dec. 20 with a reading of 115.31. The American Chemistry Council released the following statement:
The CAB is a leading economic indicator derived from a composite index of chemical industry activity. Since 1912, the indicator has given advanced notice of economic peaks with lead times of two to 14 months with a median lead time of eight months. With the reading still increasing, I do not see indications of a recession occurring within the next year. Although the American Chemistry Council does not outline conditions for when to call a recession, I have noticed that a drop of about 5% in the CAB typically precedes a recession or bear market. The 5% drop is what I will be watching for as an advanced recession or bear market warning. The CAB reading is announced monthly on the American Chemistry Council website and charts of the data can be analyzed at GuruFocus in the Economic Data section of the website.
Even with the latest rate increase by the Federal Open Market Committee on Dec. 14, financial conditions are looser according to the leverage subindex. The latest reading from Dec. 23 was -0.86 compared to -0.79 a month earlier, and -0.27 from a year earlier. The more negative the number, the looser the financial conditions are. The leverage subindex of the Chicago Fed Financial Conditions Index consists of debt and equity measures. I am watching for a reading of 1 or higher as a warning sign of a bear market in the near future. With conditions in the negative and getting looser, a bear market is not likely to be in the cards for 2017. The Chicago Fed Financial Conditions Index is updated weekly by the Federal Reserve Bank of Chicago, and just like the CAB, the leverage subindex data can be analyzed at GuruFocus in the Economic Data section of the website.
Since the markets are cyclical, the bull/bear market cycle will continue. The CAB and leverage subindex can be used to give advanced warning of the next bear market. A useful tool in determining the magnitude of the next bear market is the Shiller P/E. Nobel Laureate and Yale economics professor, Robert Shiller, created the Shiller P/E. The ratio is calculated by using the annual earnings of S&P 500 companies over the past 10 years, while adjusting past earnings for inflation. During the last market crash of 2008 to 2009, the Shiller P/E dropped from 27.4 to 13.3, a few points below its historical mean of 16.7. A drop from today's ratio of 27.9 to its historical mean would be a 40% drop in the markets. Since markets tend to overshoot both to the upside and downside, the drop is likely to be a little more, possibly in the 50% range. The Shiller P/E is also tracked at GuruFocus.
Currently, the CAB and leverage subindex is not indicating any hint of an upcoming bear market. In the past, unless the CAB has dropped 5% and/or the leverage subindex has reached a reading of one or higher, market drops have been less than 20% generally required to be labeled a bear market and have quickly rebounded. Once these warning signs have been triggered, look to the Shiller P/E for an indication of how far the markets could drop with an expectation of it dropping below the mean of the ratio. I will be watching for these warning signs and be sure to alert everyone of them. Until then, it's "game on" with the stock market.
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This article first appeared on GuruFocus .