Roche and Hussman on Tobin's Q

In response to a Bloomberg article which claimed that the S&P 500 is “unhinged from reality” based on the Tobin's Q ratio, Cullen Roche at Pragmatic Capitalism opined on Monday that the ratio is actually useless.

“But how useful is this ratio in reality?” he asked. “In my view, not very.”

“For instance, the Q ratio has been well above its historical average for most of the last 25 years. If you sold stocks when the ratio was above its historical average you’ve missed out on some huge gains.”

Roche is probably interested in timing the short-term direction of the market, and for that purpose, valuation metrics like the Tobin's Q ratio is, indeed, very probably useless, especially on their own.

Over the long term, though, valuation metrics like the Tobin's Q ratio are actually quite useful.

Just two weeks ago, John Hussman wrote that the correlation between the log of Tobin's Q and subsequent 10-year total nominal return of the S&P 500 is actually a respectable -0.85.

However, this is not the first time that Roche has doubted the value of valuation metrics. Almost a year ago, I noted in a post that he had asked how useful valuation measures are.

In that same post, I had again cited a Hussman post which showed that valuation measures have “provided clear guidance about expected market returns across a century of market history” and have “not failed at all even in recent decades”.

On the other hand, if Roche is actually interested in looking for signs that the market is about to turn rather than longer-term performance, then of course, valuation metrics like Tobin's Q are, on their own, not very useful.

Greek financial crisis may be near endgame

The euro has been rising in recent weeks, wreaking havoc on carry trades.

Still, Greece's financial problems may create more stress on the currency as the endgame to the crisis looks to be near. From Bloomberg:

Greek banks are running short on the collateral they need to stay alive, a crisis that could help force Prime Minister Alexis Tsipras’s hand after weeks of brinkmanship with creditors.

As deposits flee the financial system, lenders use collateral parked at the Greek central bank to tap more and more emergency liquidity every week. In a worst-case scenario, that lifeline will be maxed out within three weeks, pushing banks toward insolvency, some economists say...

“We are in an endgame,” ECB Executive Board member Yves Mersch said in an interview with Luxembourg radio 100.7 broadcast Saturday. “This situation is not tenable.”

S&P 500 hits new record but Transports lag

The S&P 500 rose 1.1 percent on Thursday to a new record high.

However, Mark Hulbert warned of an important Dow divergence that is ominous for stocks.

The Dow Jones Transportation Average is seriously lagging behind the broader stock market, and that’s potentially quite bearish....

The divergence began late last November, when the Dow Transports rose to a record high. They are now 6.7% below their all-time closing high (and 7.6% below the intra-day high). Over the same period, the Dow Industrials have risen more than 2%.

Citing research by Jack Schannep, the editor of a market-timing advisory service called TheDowTheory.com, Hulbert said that in the last 25 years, there have been 14 instances of big divergences between the Dow Transports and Dow Industrials. On average, the market eventually fell more than 10 percent in those 14 instances.

Even more ominous is that in five of the 14 cases, the divergences presaged a full-scale bear market.

Bonds fall but Asian junk stay afloat

Government bonds have been falling. Bloomberg reports that more than $450 billion has been wiped out across global bond markets in the past few weeks.

According to Bloomberg, the main reasons bond prices are falling are:

1. Crude oil prices have rebounded

2. Deflation concerns have receded

3. European economic growth prospects have improved

4. Too many people were invested too heavily in bonds

5. Bond yields had fallen below zero.

However, while government bond prices have fallen and yields risen, Bloomberg reports that Asia’s riskiest bond issuers are getting the lowest borrowing costs of the year.

Yields on dollar-denominated Asian sub-investment grade notes plunged 224 basis points to 7.54 percent as of May 11 from the January peak of 9.78 percent, according to a Bank of America Merrill Lynch index. That’s near the year’s low of 7.52 percent marked on April 30.

US stocks fall but bull market may not be over

The US stock market pulled back from near record highs on Monday, with the S&P 500 falling 0.5 percent.

Still, the US bull market may not be over yet.

A recent research report from Oppenheimer points out that the majority of the information technology sector trades below the market’s overall current median earnings multiple. Historically, when tech trades at a big discount to consumer staples, the market has further room to run.

Also, the investor sentiment survey from the American Association of Individual Investors for the week ending 6 May showed that only 27.1 percent of AAII members said they were bullish. That was the lowest bullish reading in more than two years.

China cuts interest rates

China cut interest rates for the third time in six months on Sunday.

The People's Bank of China said that it was lowering its benchmark, one-year lending rate by 25 basis points to 5.1 percent from 11 May. It cut the benchmark deposit rate by the same amount to 2.25 percent.

However, while China tries to stimulate its domestic economy, it may be draining liquidity from global markets. From Bloomberg:

China’s foreign-currency reserves had their biggest quarterly drop on record in the first three months of the year and the yuan is trading at the closest to fair value since 2010, according Goldman Sachs Group Inc. That means less demand for assets in dollars and euros from the world’s biggest creditor.

GMO and Hussman market commentaries

GMO thinks that bonds are no longer worth holding for most investors but stocks may still have some upside.

In the latest GMO quarterly letter, Ben Inker wrote: “At current yields, the utility of long-term government bonds in most investment portfolios is questionable at best.”

However, Jeremy Grantham in the same letter wrote that the US stock market is not yet in a bubble but will be in one eventually. “It seems logical to assume that...the current Fed is bound and determined to continue stimulating asset prices until we once again have a fully-fledged bubble.”

In contrast, John Hussman thinks that the stock market is already extremely overvalued. In his latest commentary, he wrote: “Based on the most reliable valuation measures we identify, stock market valuations are already 2.3 sigmas above reliable historical norms.”

His baseline expectation for 10-year total returns is 1.5 percent. He added: “We should not be at all surprised if the actual total return ends up being negative.”