Valuations and sentiment play into future stock market returns…as valuations indicate what people are willing to pay for a dollar of earnings. During times of exuberance, investors overpay for earnings and, during times of fear, investors underpay for earnings. Currently, two measures of sentiment are sending cautionary signals that 2018 may not be as strong of a year.

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While sentiment can be a useful investment tool, often it is only useful at extremes with various measures of sentiment having different periods of usefulness. For example, stock valuations at any given point have very little predictive power for near-term (1-year) forward returns in the market; however, the further you look out (5+ years), the more predictive they become. To see this visually, we show below a scatter plot of historical valuations using the forward price-to-earnings (PE) ratio for the S&P 500 and its subsequent return one year out (left figure) vs. five years out (right figure).

Source: JPM, Guide to the Markets (4Q 2017)

As you can see, when looking out 1 year, the data is highly scattered with no real discernable relationship between valuations and returns. At the current forward PE of 17.7 (highlighted by the red arrow), 1-year future returns have ranged as high as 30% to a loss of nearly 20%. However, the figure on the right shows a much tighter relationship, illustrating that market valuations are much better at giving us an idea of what to expect over the long-term.

That's nice and dandy, but what about the short term? Here, there are several measures of sentiment that we can use and, when they hit extremes, it pays to heed their message. Currently, two measures of sentiment are sending cautionary signals that 2018 may not be as strong of a year.

1. One such measure is the widely followed ISM Manufacturing PMI, which is a sentiment measure for manufacturing and has historically shown a close relationship with the year-over-year (YOY) rate of change with the S&P 500. This relationship is shown below with the S&P 500's annual appreciation in black and the ISM Manufacturing PMI in red.

Source: Bloomberg, Financial Sense Wealth Management

If you analyze PMI levels in relationship to forward returns for the S&P 500, you'll see that lows and highs in the Manufacturing PMI have been associated with troughs and peaks in the S&P 500's annual rate of change. For the most part, low PMI readings tend to be good buying opportunities. Here's the data we compiled going back to 1948.

Source: Bloomberg, Financial Sense Wealth Management

Looking at the table above, it is clear that forward returns for the stock market are best when manufacturing sentiment is the most pessimistic. The most recent bottom in manufacturing sentiment came in December 2015 when the PMI troughed at 47.9. Looking at the table above, the 1-year estimated return for the S&P 500 was 9.24%, which was amazingly close to the actual return by December 2016 of 9.54%. Given the above, what does the PMI say about today's buying climate? It's time to curb your enthusiasm!

The PMI reached 60.8 in September 2017 and, based on the table above, we should expect flat returns looking out 3-months, 6-months, and even 12-months out?not a very bright picture.

Source: Financial Sense Wealth Management

2. That's not all. Consumer sentiment is also giving the same message. Just as investors tend to be the most bullish near market tops and bearish near market bottoms, consumers tend to be the most bullish just prior to a recession and most bearish just as a recession is ending. Again, that's why monitoring levels of consumer sentiment can be a useful investment tool.

The relationship between consumer sentiment and the stock market is shown below where the S&P 500 is shown in black and the Conference Board's Consumer Confidence Index (CCI) is shown in red (recessions noted by vertical bars). In the present cycle, looking at monthly data the CCI bottomed the very month the stock market bottomed, which was the lowest level seen in the history of the data. The high for this cycle so far was last month where the October reading for the CCI came in at 125.90.

Source: Financial Sense Wealth Management

Similar to the ISM Manufacturing study mentioned earlier, we analyzed forward returns for the S&P 500 based on various levels for the CCI. The current reading of 125.90 ranks close to the 90th percentile of all readings going back to 1967. Said another way, only 10% of the time has consumer confidence been higher. Historically, readings in the 80th-90th percentile have led to negative forward returns looking out 1-year at -7.36%, 2-years at -22.02%, and 3-years at -26.58%. Based on the current readings, we should expect a bear market (decline of 20% or more) to occur within the next 2-3 years and a negative return in the coming year.

Source: Bloomberg, Financial Sense Wealth Management

Conclusion

We currently face a situation in which both the near-term outlook (1-3 years using ISM and Consumer Confidence data) and the long-term outlook look dismal for the stock market. While we see no evidence of a major market top or an economic recession on the near horizon, we continue to dance closer to the exits, focused on risk management as our data advises us to do.

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