Most of us don’t need any more reminders that 2022 has been a rough year for us as investors. But more intriguingly, would it have been possible to see the downturn?

For years, researchers and analysts have looked to predictive indicators as a way to foresee broader market selloffs in advance. While the market does often exhibit cyclical behavior, it’s hard to say that history perfectly repeats itself. Each economic cycle is unique, making it difficult to compare apples-to-apples to those before it.

However, perhaps there are indeed a few warning flags that investors could benefit from tracking. And those are exactly what we went hunting for in today’s 7investing podcast.

In today’s show, 7investing CEO Simon Erickson speaks with YCharts Director of Product Marketing Connor Kitko. YCharts recently published a white paper entitled Which Leading Indicators Best Predict Market Declines? In it, Connor takes a closer look at seven indicators that have been used to predict stock market selloffs:

1. S&P 500’s P/E Ratio
2. S&P 500’s cyclically-adjusted P/E Ratio
3. S&P 500’s Earnings Growth
4. “Tobin’s Q” Score
5. 10-2 Year Yield Spread
6. 10 Year – 3 Month Yield Spread
7. The “Buffett Indicator”

In the conversation, Simon asks Connor to describe each of the seven indicators and to comment on their relative accuracy. The two also discuss where the stock market currently stands with regard to each indicator, and what takeaways investors should know about the market’s status quo.

7investing and YCharts have a partnership, which offers new subscribers a 20% discount. To set up your free initial trial with YCharts and to use our promotional 7investing rate, please visit this link.

Transcript

Simon Erickson  00:01

Hello, everyone and welcome to this edition of our 7investing Podcast where it’s our mission to empower you to invest in your future. I’m 7investing founder and CEO Simon Erickson. And I don’t think I’m surprising anyone when I say that 2022 has been a challenging year for the stock market and also for most investors. But are there ways to see this coming? Are there ways to see market declines developing before they actually come? We’re going to be chatting about that topic today. I’m very excited to welcome Connor Kitco from YCharts. He is YCharts’ Director of Product Marketing. Connor YCharts is a product that I use every single day, I am genuinely a big fan of. Really nice to have you on the program here with 7investing today.

Connor Kitko  00:41

Thank you, Simon. Excited to be here and excited to hear that you’re using YCharts often.

Simon Erickson  00:46

Connor you also recently wrote a white paper. It was entitled “Which leading indicators best predict market declines”. The perfect topic for what we’re going to be chatting about here today. But maybe at the 10,000 foot level, as you were writing this white paper, what were a couple of the things that led you to it, or that you found as kind of the key takeaways from it.

Connor Kitko  01:06

Absolutely. So I think not just this year or the last few years, at any point in time, every investor is trying to have that forward looking view of the market and understand what might be coming next. But on our end on YCharts, we’re a data and investment research platform. And we’ve noticed a lot of these leading indicators, and economic data in general, has become much more popular and much more important over the last couple of years. No questions about it, because of the picture with inflation right now and the Feds involvement in setting rates and how that’s impacting the market. It’s definitely top of mind for a lot of investors and professionals. And so our question was, as we noticed more people looking at this leading indicator data, what really stands out? Is there a single indicator that can be relied on very consistently for that forward looking guidance. And we went all the way back to 1950 to gauge seven different indicators, how accurate and consistent they are for exactly that, predicting a major sell off in the equity markets.

Simon Erickson  02:19

That’s perfect Connor. And I wanted to dig into these, actually all seven of them. Keeping in mind our audience is individual investors, retail investors. We may or may not be making 50 tab spreadsheets that are tracking everything from GDP to everything else you might want to track in the macro economy out there. But I do like that these are digestible. And like you said, there’s seven of them that we can look at. Let’s start at the least reliable of these seven. The least correlated to market declines. But I’m certain that this is one that’s popular, at least for a lot of people looking at this. And that’s just the straight up the S&P 500’s PE ratio. What is this? And what did you find about it in terms of correlating to market declines?

Connor Kitko  03:00

Yeah, so we’re talking about PE ratio at the whole market level or the S&P 500 level. So if you’re familiar with the price paid for earnings per share, that’s what PE ratio is. So essentially, how many dollars are investors paying for $1 of earnings from all S&P 500 companies. And typically, it’s considered that as the S&P 500 ratio, PE ratio, increases then you would expect valuations are higher and therefore lower returns in the future. Now, in terms of just correlation to forward S&P 500 returns over one, three and five years, we found that there’s really not very strong correlation. A lot of other indicators, especially over that three and five year range, you saw, more tightly correlated values for forward returns and what those indicators were saying at a given point in time. And that just wasn’t the case with with the PE ratio. I think that that is probably impacted by just the state of valuations in the market right now. We’ve seen valuations obviously, move higher. That’s why we’re having this conversation. But I think that PE ratio is just so subject to those prices, that it’s not robust enough to be very accurate over the long term. Especially with just a new environment for PE ratios and valuations. It’s much different today than it was 10 years ago or even a couple of decades ago.

Simon Erickson  04:39

That makes a lot of sense, even though it’s not that accurate, and it wasn’t that highly correlated Connor, I know that you guys wrote in the white paper that the PE ratio of the S&P at the time was around 29.3. Given that that’s not too highly correlated, but still where does that stand in a historical context? Is that higher than we typically see the S&P PE ratio at? Which would mean it would be predictive of a decline if we were just looking at this metric.

Connor Kitko  05:06

Yeah, so it definitely is higher, it’s slightly higher over the last year than its historical average. The historical average going back to, let’s see here, the 80’s is about 24. So we’ve actually just come back down below that long term average. However, if we looked at just since 2000, like we said, that average level would be much higher, and therefore, perhaps just such as the nature of these relative indicators, when you’re comparing it against its own historical value, that’s going to change as new figures roll in. So it is anticipated, forward estimates say that the PE ratio will continue to go down, which would be a good thing for equity investors. But to be determined, and as we said, not very correlated. So perhaps not a lot of weight should be put behind that number coming down as it’s expected to.

Simon Erickson  06:05

The second indicator you looked at was also in your opinion, not that highly correlated declines, but it was the S&P’s CAPE Ratio, the cyclically adjusted PE ratio. What’s a little bit different from that from the standard and traditional PE ratio?

Connor Kitko  06:20

Right. So the Shiller CAPE ratio, Cyclically Adjusted PE, what’s different between just that standard PE is that you’re looking at a 10 year average of earnings, and those are inflation adjusted as well. So I think that this definitely comparing, it’s more robust, it’s considering a few more factors than just the straight up PE ratio. And we actually did see that over the three and five year forward returns. That the CAPE ratio actually was quite correlated to forward S&P 500 returns. Still, in the short term over the next year, it’s probably not going to give you a great indication of where the S&P is heading. But when you have that longer view, things do start to clean up in terms of the correlation. And then one thing I will note about the CAPE ratio as well is, we talked a lot about accuracy and consistency in predicting these declines. So it was relatively consistent, especially since 2000, whenever this CAPE ratio moved well beyond its own historical average, a market decline of 10% or greater has followed quite consistently since the late 90’s. However, in terms of accuracy, those warning signals of overvaluation are coming anywhere from eight months to a couple of years ahead of time. And so the average is actually about three years. Like you would get this warning from the CAPE ratio. But then you might not see that major decline come for another two and a half, three years. Not very usable for most investors, if they’re trying to, again, where’s the market heading in the next 12 to 36 months? Hard to use that and be confident in the timing of that signal?

Simon Erickson  08:20

Makes a lot of sense. So 10 years, inflation adjusted, this is a relevant indicator, it is predictive, but the accuracy and the timing is very, very challenging. You mentioned Shiller, Robert Shiller, obviously a really big fan of this. He’s published a lot of work related to the cyclically adjusted PE ratio. You noted in the paper that it was at 24. Is that high? At the time being? Obviously, in historical context.

Connor Kitko  08:44

Yes, so the cyclically adjusted cape ratio bottomed out at about 13.3, after the 2008 financial crisis, and then more recently, it was down to about 24-25, right after COVID in that March 2020 crash. We rode all the way up to highs of about 40 for this CAPE ratio at the beginning of 2022. And the level has since come down. But over the long term, something around 15 or 16 is really the long term average. And so we’re close to double that right now.

Simon Erickson  09:24

Very interesting, still very high. Of course, remember a lower PE means you’re getting a more attractive valuation on the stock market or on the S&P as a whole. The third indicator that you all looked at Connor was the S&P 500 earnings growth, just are earnings positive or negative? Tells us a little bit about that indicator.

Connor Kitko  09:44

Right. So just looking at earnings at the aggregate level across all 500 constituents and then saying is this level higher this month compared to 12 months ago? And again, not a ton of correlation especially over the short term. However, some of the extremes, when we saw very negative year over year earnings growth or very positive year over year earnings growth, those actually did correlate to better or worse returns. But this S&P 500 earnings data, it’s generally lagging quite a bit. So our most recent data point is from March of this year, and therefore, it’s perhaps not. Again, it doesn’t fit into most people’s process to be looking at data that is a few months stale in that nature. But this earnings per share across all of the S&P 500 stocks, as of March 2022, up to far and away a record high, nearly $200 earnings per share. And, that is a function of prices and earnings moving in opposite directions. However, even just as recently as the onset of COVID, and 2022, this level was just shy of 100. So around a double, a 100% increase, over the last 18 months to two years. So, that earnings growth is great to see. And that should, again, if you follow this, it would translate then to higher prices. But we’ve seen that there really wasn’t that strong of a reaction when this number goes positive or negative in terms of what the S&P 500 does next.

Simon Erickson  11:42

Certainly. Certainly a lot of short term trading around those earnings numbers and year over year comparisons. Okay, so those first three, all S&P 500 related. The PE ratio, the cyclically adjusted PE ratio, the earnings growth of the 500 largest market constituents. The fourth one is one that might be a little less familiar to most people. It’s the Tobin’s Q score, which is the replacement cost of a company’s assets. Tell us a little bit about this indicator and what you find.

Connor Kitko  12:09

Right, so the replacement cost of all company’s assets in the S&P and so, I believe you can look at Tobin’s Q on an individual company level as well. So extrapolating that out to 500 companies, I think people get a little intimidated by Tobin’s Q because replacement cost sounds so simple, but there’s a lot of math that goes into that. And it was really interesting to see, because this was one that maybe wasn’t as consistent for every single decline that we saw in the market. It wasn’t as consistent at predicting those declines. But at the very extremes over the one, three and five year forward return. So if Tobin’s Q is at this level, what historically has the S&P 500 done over the subsequent one, three and five years? Very strong correlations based on these scatter plots that we put together. So you can very easily see this line of best fit and at those very extreme values, when Tobin’s Q has been close to 1.5 or 2.0. And a higher Tobin’s Q value is regarded as above 1.0, if you would be paying more for the actual replacement costs of all these company’s assets, that would signal over valuation. So when Tobin’s Q was up to levels close to to 1.5 or 2.0, we almost always saw negative forward returns over the subsequent three and five years. However, or I mean, not however, in addition, very low Tobin’s Q values, below 0.5 always saw typically positive returns following over the subsequent three to five years. And I assume that your next question Simon is going to be where is Tobin’s Q right now? And it was as recently as the end of 2021 it was up to 1.75. So that’s very much in line, if you just use that one, anecdote, Tobin’s Q reached 1.75. And then now the market is down year to date pretty substantially. As that movement has been incorporated into the metric, Tobin’s Q is now down to 1.31. And this is another metric that while it is regarded that 1.0 is the threshold, above is overvaluation and below one is undervaluation. We did look as well as kind of that more modern threshold. We added, like a 20% premium to say, this is an alarm that would be hard to ignore, and then looked at its accuracy in predicting those declines. And that really did prove that since 2000 Tobin’s Q exceeding those thresholds is a great warning sign for impending declines.

Simon Erickson  15:08

And still like we’re not out of the woods with this one right? If we’re at 1.3 today, and you’ve put the threshold at 1.2. At least by this indicator the market is by, it’s still far from being cheap, or at least returning back to positive returns, at least at the Tobin’s Q score, right?

Connor Kitko  15:24

That’s correct. And some historical context. Tobin’s Q, there’s a lot of great historical data around this metric. However, it really spiked right around Dot Com bubble. And it has remained very consistently above a level of 0.8 ever since that happened. Only going below 0.8 at the end of 2008. So I think it’s one thing to get used to with all of these metrics is that the look back period that you’re considering is very important, because these metrics are just different beasts today than they were 40-50 years ago.

Simon Erickson  16:07

And you perfectly predicted my first question Connor, which is perfect since we’re talking about predictive indicators here today, which is where do we stand today? My follow up, I think you’re already getting me the segue to that, too. But is the S&P 500 itself changing? Are the constituents changing from being hard asset companies like GE (NYSE: GE) and manufacturers and Exxon (NYSE: XOM), with oil wells, that are out there, to be more tech companies like Amazon (NASDAQ: AMZN) and Apple (NASDAQ: AAPL)? Does that have any influence on the Tobin’s Q Score?

Connor Kitko  16:37

Absolutely, I think. I’ll just look through, I just pulled up on YCharts as you started asking this question. Top holdings for the S&P 500. No surprises here. But Apple, Microsoft (NASDAQ: MSFT ), Amazon, Tesla (NASDAQ: TSLA), Alphabet (NASDAQ: GOOGL), not until you get to Berkshire Hathaway (NYSE: BRK.B), United Health (NYSE: UNH) and Johnson and Johnson (NYSE: JNJ) are we talking about those kind of hard asset companies, like you said. And maybe even Berkshire Hathaway as a conglomerate putting that aside. The valuations for companies without revenue and the way that those have broken into the top levels of these market based indexes? And then also just what is their, what comprises of their assets? Like you mentioned, are we talking about, real bolted to the ground PP&E? Or are we talking about intellectual property and stuff like that? So it is an interesting one, just as those companies, their revenues, their business models, their revenue structures, what they hold in terms of assets, their debt structures, all those things are definitely impacting, I think, the current market dynamics compared to the old.

Simon Erickson  17:55

Well, there’s four down, we’ve got three to go. You know, I don’t know how it is for you, Connor. But in my world, I could not go a single day without hearing Jerome Powell said at least 10 to 20 times in conversation. It seems like we’re all focusing on interest rates right now. And actually, the fifth indicator is the yield spread between the 10 year note, and the 2 year note, the 10-2 yield spread. This is of course the difference between the interest rates being paid by the 10 year treasury and the two year treasury. We actually can see that go negative and invert, which is something we did see earlier this year, for a short amount of time. Tell us a little bit about this indicator?

Connor Kitko  18:32

Absolutely. So this is the 10 year to 2 year yield spread. And we’ll talk about another spread, I’m sure shortly. Particularly interesting, in my opinion, because we’ve talked a lot about correlation to those forward returns. And these metrics are not very correlated at all. And I think that comes down to the fact that it doesn’t matter what the value is, as long as it’s above zero, when we’re looking at these yield spreads. You know, obviously, tightening markets or loosening markets is one thing, but because we’re just considering, okay, it’s very binary, positive or negative. The actual level of the spread over time, might vary widely while still being positive. So we actually saw pretty weak correlations to those forward returns. However, the second part of our analysis was looking at those warning signals. So when one of the spreads goes negative, when this 10 year to 2 year spread goes negative, what happens with US equities following? And these are also largely considered economic indicators. You know, people look at the spreads to determine if we’re going into a recession, first and foremost. And we know the stock market is not the economy but we all feel and see the stock market I think more tangibly as investors. And so since 1978, when this yield spread goes negative, the 10 to 2 year spread, a major market decline has followed 10.5 months after that inversion occurs. And that’s, since 1978, it has accurately predicted almost half of those major market declines of 10% or more. So.

Simon Erickson  20:26

That’s the S&P 500 decline?

Connor Kitko  20:28

An S&P 500 decline, correct. Yeah. And so it is interesting, because I just noted, even just half of these major market declines it gave an accurate warning for, so take that with a grain of salt. However, that 10.5 month warning window, I think is much more actionable for investors. Because they can say, okay, if the markets going to top in 10 months, I have a little bit more insight into how to position myself versus talking about three to five years down the road.

Simon Erickson  21:07

Yeah, absolutely. And for anyone listening that might not be as familiar with what inversion means or negative spreads means. This means that the two year note is paying a higher interest rate than the 10 year note is. Rates have gone up so quickly, in such a short amount of time that it inverts the curve, that’s very rare, as Connor was mentioning.  It certainly has an impact for the S&P 500 returns. We didn’t talk as much about the economy as a whole. But it’s also very predictive of recessions as well, as the economy tries to catch up with rising interest rates over a short period of time. Speaking of indicators, you correctly predicted that I was going to ask this next one, which is we just talked about the 10 and 2 year spread. How about the 10 year and 3 month yield spread? That’s actually the sixth indicator you have on your list.

Connor Kitko  21:53

Exactly. And I think that most people, I think the 10 to 2 year is traditionally the more popular of these yield spreads. And as you commented Simon, this is just like a breaking down of how interest rates are supposed to work. If you tie up your money for longer, you should be rewarded more. If you tie up your money for shorter periods of time, you should be rewarded less. But that’s not what’s happening with these government treasuries. And so the 10 year to 3 months is a little more nascent, I’d say, than the 10 to 2 year spread. However, it was actually a superior predictor of those major declines. And if I get back to my table here.

Simon Erickson  22:40

Can I double click on that Connor.  You said that the superior predictor was the 10 year and 3 month spread as compared to the 10 year to 2 year? Did I hear that right?

Connor Kitko  22:48

That’s correct. And so you are actually with the 10 year to 3 month spread slightly more accuracy. So 16 major market declines for the S&P 500, a 10% or more drawdown, it predicted 50% of those declines as the 16 major market declines. The warning that it gives is actually a little bit more advanced than the 10 year to 2 year spread. So this gave a 12 month, a 12.8 month warning, whereas the 10 year to 2 year spread gave that 10 and a half month warning. So slightly more notice, slightly more accurate in terms of that warning sign being followed by a major market decline.

Simon Erickson  23:39

Great, okay, we hear a lot about yield spreads. Those are certainly a popular topic of conversation here. Let’s go to the seventh and final, the most accurate, the most relevant and highly correlated to market declines. It is the Buffett Indicator, no doubt named after Warren Buffett. I know Warren Buffett, but I’m less familiar with this indicator. What can you tell us about this one Connor?

Connor Kitko  24:00

Yeah, so the Buffett Indicator, if you’re looking for it within YCharts, it’s just called S&P 500 Market Capitalization as a Percentage of US GDP, gross domestic product. So Warren Buffett, his name has been slapped on this indicator. I don’t know if he gave permission for that. But he has been quoted saying that this was, in his opinion, the single best indicator of where valuations stand at any point in time. And very similar to the Tobin’s Q which we discussed. This indicator would say that if the market capitalization of all companies is greater than the GDP of the United States, then the market is overvalued. And I think this one is interesting for kind of comparing those, or involving both them market piece with a market capitalization and economic component with gross domestic product. But this Buffett Indicator, very strong correlations over the three and five year forward looking returns for the S&P 500, albeit not as correlated over the short term. And then again since 2000, since 1999 in fact, it has only missed one major market decline of the, I think, it looks like 11, or nine, or 10, that we looked at since 1999. So very consistent. When this Buffett indicator moves beyond those critical thresholds a market decline tends to follow.

Simon Erickson  25:46

And where do we stand with this right now? How does the Buffett Indicator look, comparing market caps versus GDP today?

Connor Kitko  25:52

It’s a great question. And particularly because the one potential drawback with this metric is that it has remained very elevated, since COVID, and even some time before COVID, since about 2015 or 2016. It’s broken that 120% level, and traditionally 100% is that critical threshold. So it has remained, I guess, in warning mode for some period of time.  However, part of our research process was to add a slightly higher threshold to say this is a warning sign you could not ignore. And, the Buffett indicator right now at 151% as of the end of June 2022. So market capitalization is 150% higher than GDP. We’ve also seen now those two negative quarters of GDP growth. So I think even though, it’ll be interesting to see what happens next, what moves by a greater degree. If GDP continues to fall, but prices in the market also continue to fall then we’ll see what happens with the Buffett Indicator going forward?

Simon Erickson  27:10

Yeah, fantastic. Well, there’s the seven indicators Connor. Like we mentioned, from the less predictive to the more predictive we had the S&P 500 PE ratio, the S&P 500 Cyclically Adjusted PE ratio, the S&P 500 earnings growth, the Tobin’s Q Score, looking at replacement costs of assets, the 10 year and 2 year yield spread, the 10 year and 3 month yield spread, and then the Buffett Indicator. I mean, just to tie this all together now Connor. At 7investing we’re looking at businesses, we are investing into businesses we want to hold for the long term. And certainly stock market returns follow one of three things generally. Fundamentals growth, are they growing earnings and revenues in all the fundamentals of the business. The valuation multiples that the market is willing to give them. Is it elevated? Is it is it more of a pessimistic view of it? And then dividends. And I think that all of this conversation, or at least a lot of it kind of goes back to, in aggregate, if we’re looking at the S&P 500, or the American economy, or the yield rates that are out there, it seems to be kind of a nice consolidation of how is business in America looking? Versus how is the market valuing those fundamentals? Any kind of final thoughts, as you conducted this fantastic white paper, anything that investors should be thinking about as we as we move forward here?

Connor Kitko  28:32

Yeah, I think that just to sum up our research, we did not find a single silver bullet indicator that you should, keep up on your second screen at all times. However, we did note that combining things like the Buffett indicator and those yield spreads, if you can consider all of those as you’re going throughout your year or considering your decisions, that combines what we saw as great components of both the market and the economy into your decision making. I think, as you noted, looking at individual companies, we obviously just looked at the market as a whole. But I think it would be wise for investors to think about, this stock, this company that I’m considering investing in, is it one that’s typically above or below the market average valuations? And then maybe by looking at the market level valuations that can give you a good clue as to wherever this business is, in terms of sector or industry and the economy and the economic cycle. Are its valuations, concerning or attractive right now, relative to what I’m seeing with the market as a whole?

Simon Erickson  29:48

Fantastic Connor. If we wanted to read your white paper up on YCharts, what would be the link or the URL that we could use to get there?

Connor Kitko  29:55

Yeah, it would be https://go.ycharts.com/which-leading-indicators-best-predict-market-declines and I’m sure we can get that listed, but https://go.ycharts.com/which-leading-indicators-best-predict-market-declines.

Simon Erickson  30:08

Perfect, and we will put a link to that URL up on the podcast here with 7investing. Once again Connor Kitko is YCharts Director of Product Marketing. Connor this was a lot of fun. Thanks for chatting with me on the 7investing Podcast.

Connor Kitko  30:20

Thanks a ton Simon and good luck with the rest of the year.

Simon Erickson  30:23

Absolutely. Good luck to everyone who’s listening to this program. We appreciate you joining in for this time around. My name is Simon Erickson, and once again we are 7investing. It’s our mission to empower you to invest in your future. Have a great day.