When we made the decision to use ETF’s instead of value stocks in our October 25 Value Alert newsletter, it was a decision based on practicalities. Value stocks have simply stopped working as the bull market has matured. However, we now feel that the entire market is reaching valuations that may be closing in on obscene. Here’s why…

When the October 25, 2015 newsletter (in which we lamented the overvalued conditions) was published, we commented that the S&P 500 P/E ratio was at 18.23 and the Russell 2000 P/E ratio was at 71.7. The average P/E ratio for the S&P 500 since the 1870′s has been about 15.5, so the S&P 500 was slightly elevated two weeks ago. Data for the Russell 2000 is not as readily available, but according to Russell Investments, which introduced the indices in 1984: “The average P/E of the Russell 2000 since 1998 has been approximately 17.0, vs. 13.5 during the period (from 1984 to) 1998.” Therefore, the Russell was extremely overvalued two weeks ago. But now, it has a valuation that is jaw-dropping.

In writing today’s article, I just checked in with the Wall Street Journal Market Data Center to get an update. The S&P 500 P/E ratio is now significantly higher at 23.41, and the Russell 2000 P/E ratio is at a mind-boggling 188.46. Check for yourself.


Those incredibly high prices are accompanying declining revenues and profits, a trend that we have discussed several times in previous newsletters.

In the current earnings reporting period, nearly one-third of S&P 500 corporations have reported earnings and revenue from the third quarter. With 147 companies reporting so far, profits are down -0.6% and sales are down -2.7% from a year earlier.

151108_declining_revenues_and_earnings_smIt seems logical that several quarters of contraction in earnings and revenue would have weakened stocks. After all, if robust sales and healthy profits are the primary drivers behind price appreciation for publicly traded companies, shouldn’t diminishing sales and dwindling profits lead to price drops for publicly traded corporations?

Welcome to the bizarre world of central-bank planning, worldwide stimulus, and currency wars in a race to the bottom. Despite the plummetting fundamentals, the S&P 500 is within 2% of its all-time high and the Nasdaq 100 set a new all-time high last week. And, of course, the Russell 2000 has the highest PE ratio ever recorded!

The Status of the Economy

Many are saying that the recent weakness in small-cap stocks is an indication that the economy is about to enter a recession.  However, value investors believe it’s foolish to look towards the market for advice on the economy.  Instead, we view the market as a potentiator of stock-buying opportunities.  Rather than the market, we watch employment statistics and the yield curve.  Those two economic indicators have a 100% accurate record of predicting downturns since 1932.

Unemployment continues to drop and after last month’s 288,000 increase in jobs, the unemployment rate has reached a five-year low of 6.3%, dropping from 10% in early 2009.  We would need to see a couple of month’s reversal of that trend to signify an economic downturn.

Chart 1: The unemployment rate continues to drop as the economy strengthens. Courtesy of Bureau of labor Statistics.

The Yield Curve is the difference between the yield on 3-month Treasury Bills and 30-year Treasury Bills.  A steep yield curve indicates that investors are not yet piling into short-term bonds in an effort to avoid an economic downturn.  A flat yield curve indicates that investors are buying up the short-term bonds, and the demand has forced yields as high or higher than long-term thirty-year bonds.

Chart 2 below shows the flat yield curve at the end of 2007, just before the 2008 recession hit while Chart 3 shows today’s yield curve which is about as steep as it has ever been.  You can see an animated version of these charts for 1999 to present at

The yield curve goes flat when the economy is overheating, and smart money recognizes that fact, moving money into the safety of bonds.  However, instead of growth that causes overheating, we see steady growth of about 2.5%, accompanied by low inflation. Today’s economy is about as good as it can get: slow but steady growth with no signs of overheating, the perfect combination for long-term value investors.

Chart 2: The yield curve before the last recession was almost inverted.

Chart 3: The yield curve today is still very steep.

Having said all that, it has been three years (2011 debt-ceiling fiasco) since we have seen a surprise-shock to the economy, and we are overdue.  The corporate profit margins, as well as the Graham 10-year PE ratio, are also at historic highs and can’t remain there forever.  Therefore, we will maintain a conservative posture and continue to use fixed stops (on a closing basis) at this time.  We will be taking those stops off as soon as we see confirmation of the market upturn discussed below.