More data beats than misses is an encouraging sign for stocks. Over the past 10 years, when the CESI breaks above zero (14 instances), the S&P 500 was higher over the subsequent 6 months 79% of the time with a median gain of 5.2% (the average is lower, dragged down by a 35% drop in 2008). Excluding the Great Recession, stocks rose in 11 of 12 instances with a median gain of 6.3% (and an average of 6.9%) over the subsequent 6 months. We have also observed better performance from the more economically sensitive sectors in these scenarios. Both good signs.

The second quarter 2016 gross domestic product (GDP) report will be released this Friday, July 29, which may deliver another surprise. GDP is expected to pick up strongly from the tepid 1.1% annualized growth rate posted in the first quarter of 2016. The Bloomberg consensus forecast for the second quarter is 2.6%.

Something else that is poised for a breakout after an extended stay below zero is earnings growth. After what will likely make four consecutive quarters of earnings declines in the second quarter of 2016, consensus estimates are calling for a modest low-single-digit gain in the third quarter. More on earnings in the coming weeks.

Breakout #2: valuations

Our next breakout is not as upbeat, and that is valuations. Based on the trailing 12 months price-to-earnings ratio (PE), one of our preferred valuation measures, stock valuations have broken out to a new post-financial crisis high. In fact, you have to go back more than 11 years—to November 2004—to find a higher PE than the current 18.3 [Figure 2].


These lofty valuations are understandably concerning to many. Most bull markets since WWII have ended at similar PEs to where we are today (the 1990s bull market ended at a much higher valuation of near a 30 PE). These multiples are now above long-term averages. Stock market corrections tend to be more painful when they come at higher valuations.

Even more worrisome, some other valuation measures look even more stretched than this one. Professor Robert Shiller’s Cyclically Adjusted PE ratio (or CAPE), which uses 10-year average S&P 500 earnings, is over 26, versus a long-term average at 17. The median PE for stocks in the S&P 500 is 23, compared with an average of 17. And the S&P 500 PE based on GAAP, or as reported accounting earnings, is 21, above its average at 18. These are all valid concerns and certainly play into our cautious second half outlook for stocks.

Two things keep us from getting overly worried about this breakout. One, valuations have not historically been good market timing tools (Shiller publicly admits this about his own valuation metric). From year to year, it is random whether higher or lower valuations will lead to better returns. And second, inflation and interest rates are low. Lower interest rates and less inflation make future earnings more valuable and make bonds a less attractive opportunity than stocks. We continue to watch for downside catalysts that may suggest valuations will become problematic.

The PE ratio (price-to-earnings ratio) is a measure of the price paid for a share relative to the annual net income or profit earned by the firm per share. It is a financial ratio used for valuation: a higher PE ratio means that investors are paying more for each unit of net income, so the stock is more expensive compared to one with lower PE ratio.

Breakout #3: Emerging markets