The overriding problem for the equity market remains one of valuation – not that we are in bubble territory, but more that the stock market is still quite expensive.
The price action of 2015 failed to resolve one thing, which was to correct the excess valuations that held back the market last year as it likely will this year too.
The trailing price-to-diluted earnings multiple is 21.4x versus the historical norm of 17.5x, while the forward multiple on the S&P 500 is 16.8x, and again, the mean has been closer to 14.4x. The Shiller cyclically-adjusted price-to-earnings (CAPE) ratio is 26 and the long-run average is 23. Capish?
So here we have the stock market, according to many measures, trading close to three multiple points above historical norms.
Like the personal savings rate in the macro world, the price-earnings multiple in the financial world is a behavioral aggregate – a signpost of confidence, if you will. A lower savings rate is symbolic of higher confidence over income or wealth prospects, and similarly a higher multiple is a characteristic of rising investor confidence over the outlook for market returns.
The problem is that we do not have the clarity, certainty or visibility across the globe, whether it comes to policy, oil prices, regional conflicts or China, to warrant multiples being this far above the norm, if at all.
So, 2016 is likely going to be a year of transition and one where uncertainty is going to dominate the macro and investing landscape.
The fact that oil prices could not catch much of a bid given the conflict between Iran and Saudi Arabia should have the bulls shaking their heads.
The reality is that supply is an impediment at a time when there has still not been a dent in U.S. production and OPEC has been pumping out 32 million barrels per day (far above its quota) for seven months in a row.
The severing of diplomatic ties between Iraq and Saudi Arabia could be problematic for investors risk tolerance if the situation turns worse, as in some form of military response. At a minimum, it complicates efforts to resolve the internal crisis in Syria.
It also further exposes the failure of U.S. foreign policy under the current administration (underscored by the surge in Aerospace & Defense sector stocks last year).