Stock Market Indicators

Cake Stock Market Bubble Barometer

The Cake Investment Plan Bubble Barometer provides insight into whether or not the stock market is in an unsustainable bubble or not.  This is helpful in preparing for market turns both within the Cake Investment Plan portfolio as well as in the rest of your financial affairs.

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Stock Market Bubble Barometer Component #1

The first component of the Cake Bubble Barometer is the Q Ratio.  The Q Ratio is a popular method of estimating the fair value of the stock market.  This was developed by Nobel Laureate James Tobin. It’s a fairly simple concept, but time consuming to calculate. The Q Ratio is the total price of the market divided by the replacement cost of all its companies.  Tobin’s Q = Equity Market Value​                                                                                                                                                                                                                                                     Equity Book Value   

Fortunately, the government does the work of accumulating the data for the calculation. The Federal Reserve supplies the numbers in the Federal Reserve Z.1 Financial Accounts of the United States.   The Fed  releases these quarterly.

Unfortunately, the Q Ratio isn’t a very timely metric. The Z.1 data is over two months old when it’s released.  Also, three additional months will pass before the next release. To address this problem, The Cake Investment Plan monthly updates include an estimate for the more recent months based on changes in the VTI price (the Vanguard Total Market ETF).  This acts as a surrogate for Corporate Equities; Liability.

At its most basic level, the Q Ratio expresses the relationship between market valuation and intrinsic value. In other words, it is a means of estimating whether a given business or market is overvalued or undervalued. The higher the number the more overvalued is the market.

Stock Market Bubble Barometer Component #2

The second component of the Bubble Barometer is the S & P 500 Price to Earnings Ratio as developed by Robert Schiller.  The price-earnings ratio, also known as P/E ratio, P/E, or PER, is the ratio of a company’s share (stock) price to the company’s earnings per share. Investors value companies as over or under valued based on the ratio.  They calculate the S & P 500 PE Ratio based on the trailing twelve months “as reported” earnings.  Investors calculate this ratio from latest reported earnings and current market price.    This also gives us an insight into whether or not the market is overvalued.

Stock Market Bubble Barometer Component #3

The third component of the Bubble Barometer is the Cyclically Adjusted Price Earnings Ratio.  Robert Schiller also developed this.  The S&P 500 Shiller CAPE Ratio, also known as the Cyclically Adjusted Price-Earnings ratio.  This is defined as the ratio of the S&P 500’s current price divided by the 10-year moving average of inflation-adjusted earnings. This is useful because volatility in per-share earnings also results in price-earnings (P/E) ratios that bounce around significantly.  Benjamin Graham and David Dodd recommended in their seminal 1934 book, Security Analysis, that for examining valuation ratios, one should use an average of earnings over preferably seven or ten years.

Stock Market Bubble Barometer Component #4

The final component of the Bubble Barometer is the Inventory to Sales Ratio.  The inventories to sales ratio show the relationship of the end-of-month values of inventory to the monthly sales.  We use these ratios as indications of the number of months of inventory that are on hand in relation to the sales for a month.  For example, a ratio of 2.5 would indicate that businesses have enough merchandise on hand to cover two and a half months of sales.  Many consider this a recession indicator and indeed it can be so.  We, however, feel it is a better indicator of a bubble as it gives indication as to whether current production levels are sustainable.  The higher the number, the greater chance that there is malinvestment that has been caused by artificially lower interest rates that has distorted the capital structure of the economy.

Summing Up the Cake Stock Market Bubble Barometer

The Cake investment Plan blends and weights these indicators in a proprietary manner.  This produces a number that gives insight into whether or not the market is in an unsustainable bubble.  It also tells how large that bubble has become.  Any number over 100 means the market is in a bubble. There is no cap on how high the metric can rise.

Cake Recession Indicator

The best indicator for intermediate term recession risk is the growth rate of the money supply. This stems from the insight offered by the Austrian school of Economics and the Austrian Business Cycle Theory. Central Banks create unsustainable booms by creating money and those bubbles burst when the growth rate slows by enough for long enough to expose the malinvestment.

Step #1

The Cake Recession Indicator relies on two definitions of the money supply. First, we use the standard M2 definition. M2 is a calculation of the money supply that includes all elements of M1 as well as “near money.” M1 includes cash and checking deposits, while near money refers to savings deposits, money market securities, mutual funds, and other time deposits. These assets are not as suitable as exchange mediums because they are less liquid.  These assets are, however, quickly converted into cash or checking deposits.

Step #2

Second, we use the so-called True Money Supply (TMS) definition, developed by economists Murray Rothbard and Joseph Salerno. This was designed to provide a more accurate measure of money supply fluctuations than M2. This measure of the money supply differs from M2 in that it includes treasury deposits at the Fed (and excludes short-time deposits, traveler’s checks, and retail money funds).

Step #3

Then, we blend in the daily tax withholding receipts of the federal government. This is the best indicator of the current health of the economy. Government statisticians constantly revise growth rates and sentiment indicators, but no business pays withholding tax on phantom jobs.  This is also a leading indicator, unlike the actual unemployment rate, because before layoffs occur, businesses will cut back on overtime and hours worked as well as cease to create new positions, so taking this metric into account helps provide needed clarity.

Summing up the Cake Recession Indicator

The relative weighting of these two monetary metrics, as well as the movement of the daily tax withholding flows and their interplay provides the raw data which our proprietary formula turns into an indicator weighing the risks of recession within the next 18-24 months. The scale is 0 to 100 and any value above 75 indicates a high probability of recession.

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