Canaries and Coal Mines

This past weekend I spent much of my time building an aviary in our backyard. Not being much of a carpenter, the process was interesting and quite challenging. But between the whir of the drill and screech of the circular saw I thought a lot about the canaries we'll be housing, their sentinel work in coal mines, and questions from clients lately about market bubbles.

Maybe 150 years ago coal miners started using canaries (and sometimes mice, but canaries were the favorite) to test for carbon monoxide gas. The colorless, odorless, and tasteless gas would affect the canaries more quickly than humans and if the bird swayed and collapsed, the miners knew they had a problem and could head for safety or grab a respirator. This low-tech but effective process lasted until about 30 years ago and, for whatever reason, the "canary in the coal mine" idiom became deeply etched in our psyche as a warning sign of coming danger.

Lately there has been an uptick from clients asking about the stock market being in a bubble. With the Dow Jones Industrial Average crossing 22,000 last week and the media coverage of this, some folks are concerned that what has gone up must come down and that the gravitational pull is getting stronger every day. As a reminder, these number thresholds are interesting but are purely psychological. It's newsworthy in the sense that people tend to favor round numbers and it illustrates growth, but otherwise it's just a headline. Personally, I think the Dow is more prominently featured in the news because it's only one syllable to the S&P 500's six, so it sticks in the brain better.

Additionally, the index is comprised of only 30 companies and, as the saying goes, the Dow is not the economy and the economy is not the Dow. In other words, one would not look at the Dow alone to gauge what kind of shape the market and economy are in. A better view would be had from watching the S&P 500 (the S&P).

Since we don't have canaries sitting on our desks watching the markets every day (as least I don't), we do watch a wide variety of indicators for signs of impending doom. Arguably, none of the major indicators are flashing extreme warning signs and the outlook is mostly positive, but there are always risks to that.

While there is no single best indicator, or canary, here are a few of the major ones:

P/E Ratios

The price/earnings ratio is a measure of how much an investor must pay for $1 of corporate earnings. There are variations on this theme but the basics are that every company has a ratio based on past earnings and expected earnings. The "price" component is the company's stock price while the "earnings" portion is either what the company has recently reported, or what analysts think the company is likely to report.

Some companies have very high P/E's while some are relatively low, and this moves around based on current share price and realized and expected earnings. These individual company ratios are then averaged across a broad-based index, such as the S&P, to get an idea of how "expensive" the market is.

Currently, the average P/E of the S&P is just over 21 compared with a historical average of about 17. This indicates a stock market that is overvalued, but not abnormally so. For example, the S&P's P/E was twice as high in the late-90's before the tech bubble burst. If companies can continue to grow profits (the current assumption), this should support higher than average P/E's for a while.

Earnings Season

Analysts try to figure out how much money companies can make and then the companies are measured against these expectations during "earnings season" each quarter. Sometimes expectations are overly optimistic or pessimistic, but market watchers tend to focus on the average of companies in the S&P to gauge how Corporate America is doing.

So far this earnings season about 61% of companies have beaten expectations, with earnings down a bit from prior quarters but with higher revenues. Additionally, more companies are raising their guidance, or stated outlook, to analysts. This helps the "E" in the P/E ratio which helps buoy stock prices. How long with this continue? Corporate America's outlook seems fairly positive.

ISM Composite

The Institute for Supply Management surveys businesses in the manufacturing and services sectors and publishes an indicator trying to show whether the economy is expanding or contracting. A reading below 50 indicates a slowing economy while a reading above 50 indicates expansion. Currently at about 54, the composite index is down a bit lately but is still reflecting an expanding economy.

Should this indicator drop below 50, corporate profits would suffer and stock prices would need to decline to bring the P/E ratio back more in line with reality. But we're not there yet.

Consumer Confidence

The Conference Board reports consumer confidence data each month. For an economy like ours that's 2/3rds consumption-based, it's important to see how consumers feel about a variety of issues now, and what their expectations are for the future.

From the Conference Board's July report, consumers see an expanding economy and are more confident about their current situation and job prospects. Maybe ironically, consumers were less confident about their personal income rising but their overall outlook is improving. Could this have to do with consumer credit and student loan debt now being at record highs? Time will tell how problematic that becomes for the economy.

These are just some of the major indicators and they are more or less positive. Yes, the stock market is at record highs but the data seems largely supportive of this.

The market has been quiet and resilient to a variety of news lately but it's best not to be shocked when volatility rears up again. As we're all aware, the stock market can't go in one direction forever. So, while we can't rely on canaries as our clear sign of danger, we need to be prepared to deal with the downside volatility that comes along with investing. It may be awhile yet but it will come back eventually.

Have questions? Ask me. I can help.