A Different Look at the Market Provides a Conclusion That Will Scare You

Technical analysts are familiar with breadth indicators. This is a class of indicators designed to measure how broad the participation in a price move is.  The general idea behind breadth indicators is that a healthy trend will have broad participation. In a bull market, for example, most stocks should be in uptrends.

This is based on the theory that a market with just narrow leadership is likely to reverse. This was seen in 2000 when just a few stocks were moving higher. These stocks carried a great deal of weight in the indexes and pushed the indexes up. Breadth warned of a problem and the bear market was a problem.

A popular breadth indicator is the advance-decline line which is calculated by subtracting the number of stocks declining every day from the number of stocks advancing.

A/D line = advancing issues – declining issues

Every day, technicians complete this simple calculation and chart the result, adding today’s result to the data. The result is shown in the chart below. Generally, we see a line (the breadth indicator) that closely tracks the price action.

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Technicians become concerned when breadth indicators diverge from the trend in prices. A divergence develops, for example, when the direction of the price trend is up but the direction of the A/D line is down. This would indicate most stocks are in downtrends and the price trend is likely to change.

The Breadth of Fundamentals

When analyzing breadth indicators, technical analysts are generally looking for short term trends. There are tools and techniques technicians can use for longer term analysis but breadth analysis is usually focused on the short term.

Fundamental analysis, on the other hand, is generally focused on the long term. Fundamental analysts will study financial statements, using data that us updated just once every three months. The relatively slow pace of changes in the data drives a longer term perspective analysis for practitioners.

Tools of fundamental analysts are well known. They often consider different ratios based on financial statements to develop a market opinion. A financial statement actually consists of three different components and its possible to derive a ratio based on data from any of the components.

The first part of the financial statement is the income statement. This includes information about sales, expenses and income. Analysts created the price to earnings (P/E) ratio and price to sales (P/S) ratio to gauge the value of a stock based on the information in the income statement.

The next part of the financial statement is the balance sheet. Here the company provides information about its assets and liabilities. Analysts subtract the amount of liabilities from total assets to find the book value of the company. They can then use the price to book value (P/B) ratio to value the stock.

The final part of the financial statement is the statement of cash flows. This statement records how a company uses cash. Analysts have developed a number of calculations to help them interpret cash flow. Among the most popular tools are those associated with free cash flow (FCF).

FCF is a measure of a company’s financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. The price to FCF (P/FCF) ratio is used to measure a stock’s value.

These tools are generally applied to an individual stock. For example, we may want to know whether a stock is cheap, relative to its peers, based on the P/E ratio, the P/B ratio or some other measure. There are also a number of other tools that can be used to value stocks.

Less popular is the idea of applying breadth analysis to fundamental indicators. For example, we could find how many stocks are trading with a low P/E ratio.  This would tell us whether or not the market as a whole is more generally overvalued or undervalued.

Breadth of Fundamentals

Fundamental analysts generally look at stocks as buys when the fundamental ratios are low. Stocks could then be considered for selling when the fundamental ratios become too high. Of course, the idea of what is high or low will need to be defined.

For our purposes, we will look for value, counting the number of stocks that have low ratios. This will tell us what percentage of the market can be considered undervalued for different ratios. Applying this tool to several ratios will allow us to make an observation as to whether the broad stock market is overvalue or undervalued.

To begin with, we will start with the P/E ratio. Value investors tend to favor stocks with low P/E ratios. Some will want a very low ratio, perhaps below 10 or even below 5. We are looking at the market as a whole and will define value as stocks with P/E ratios below 15. This is generally accepted as the long term average P/E ratio of the market.

We screened a database that included 7,065 stocks. We found that 749 of those stocks had a P/E ratio below 15. In other words, 10.6% of the stocks in the database have a low P/E ratio. This is shown in the chart below as 11% due to rounding.

The chart above includes similar counts for other ratios. Valuation metrics using the income statement (P/S and P/E ratios), the balance sheet (P/B) ratio and the statement of cash flows (P/FCF) are used. The PEG ratio is also shown.

The PEG ratio compares the stock’s P/E ratio to the company’s reported earnings per share (EPS) growth rate. This indicator recognizes that investors are willing to pay a premium for growth. For example, companies growing earnings at 30% a year, for example, should have a higher P/E ratio than a company that is growing earnings at 3% a year.

The PEG ratio accommodates this fact. The ratio is found by dividing the P/E ratio by the EPS growth rate. A ratio of 1.0 indicates a stock is fairly valued. PEG ratios less than 1 highlight stocks that are undervalued no matter what their P/E ratio is. PEG ratios greater than 1 show a stock is potentially overvalued.

In the chart above, we show that just 4% of stocks have a PEG ratio less than 1. For the P/E ratio, as noted above, we used a value of 15 as our cutoff. The P/S ratio we used was 1, the same value used with the P/B ratio. For P/FCF, we set a cutoff of 15.

The conclusion from this chart is readily apparent. No matter which valuation metric is used, there are few stocks that can be considered undervalued. The market, as a whole, appears to be overvalued and vulnerable to a selloff.

This analysis can help us forecast the depth of the expected selloff. We should expect that the time the next bear market is over, a majority of stocks will be undervalued. Given the degree of overvaluation in the current market, the coming bear market is likely to be deep.

Some Stocks to Consider

For those looking for value in the current market, there are a few stocks that are cheap on all of our screens. These include Gulf Resources (Nasdaq: GURE), AU Optronics (NYSE: AUO), LG Display Co. (NYSE: LPL), Consumer Portfolio Services (Nasdaq: CPSS) and AEGON (NYSE: AEG).

During a bear market, that list of buy candidates will grow and value investors will be rewarded for their patience.