I woke up this morning (1/23) to this headline on ZeroHedge:

CNN Politics:  BREAKING:  China Dumps All Bonds, Declares South China Sea Zone Closed

My first thought was "Oh! S***" here we go. My nightmare scenario has become a reality.  I quickly flipped over to my markets page to find stock futures deep in the red by....wait a minute...less than 1%?  That can't be right? If the nightmare scenario was upon us then markets should be crashing.

Sure enough by the time I got back over to ZeroHedge the page had been updated to show:

"Luckily this time it was merely a hack, as can be seen by the 'article's' subsequent deletion from the live page and CNN's mea culpa:

CNN SAYS SOME OF ITS SOCIAL MEDIAL ACCOUNTS WERE COMPROMISED

CNN SAYS COMPROMISED ACCOUNTS INCLUDE TWITTER PAGE, FACEBOOK"

While this was not the ideal way to start my morning it did get me to thinking about valuations, profits and what could cause a real correction in the markets.  That is the premise behind today's "Things To Ponder" for your weekend homework.

1) Valuation Update: Stocks Are Expensive by Doug Short

If you don't read Doug's site daily you are really missing something as part of your daily research.  I always dedicate some of my time to review his valuation studies (here, here and here) in particular but most importantly, for me, is the combined study of 4 different valuation measures. 

"Here is a summary of the four market valuation indicators I update during the first days of the month. The four indicators are:

The Crestmont Research P/E Ratio

The cyclical P/E ratio using the trailing 10-year earnings as the divisor

The Q Ratio, which is the total price of the market divided by its replacement cost

The relationship of the S&P Composite price to a regression trendline"

"The next chart gives a simplified summary of valuations by plotting the average of the four arithmetic series (the first chart above). I've also included a log-scale area chart of the real (inflation-adjusted) S&P Composite along with recessions."

Doug correctly notes that valuation levels are not useful as short-term signals of market direction as "irrational exuberance" or "extended despondency" can last far longer than logic would dictate.  However, with combined market valuations now at levels only seen before horrific market corrections it may be prudent to think that most of the "low hanging fruit" of this current bull cycle has already been harvested.

2) Overvaluation: The Evidence via The Economist

The Economist also picked up the theme of overvaluation recently but also made a very important point about media bias stating:

"INVESTORS get bombarded with advice over whether to buy shares. Much of this comes from interested parties; brokers or fund managers, whose salaries are dependent on getting them to buy stocks. The media chips in too, but most reporting consists of trend following; if the market goes up, journalists quote someone who can explain why the market has gone up.

The problem with this approach is that investors (and commentators) can get carried away with the crowd. Of course, everyone is bullish when the market is at an all-time high; that is why the market is high. What we need is a reliable valuation measure. Then you can sit back and say "buy when the market is cheap" and sell, or at least not buy, when it is dear."

"Another reason to trust the CAPE is that its message is replicated by a completely different (and independently-calculated) measure; the Q ratio (see chart). This compares share prices with the replacement cost of companies' net assets. In simple terms, if the Q ratio is high, then it will be cheaper to buy assets in the market than to buy the shares of companies that own those assets; if the ratio is low, then shares will be a bargain for their asset content. Over the long run, arbitrage should close the gap.

Now there are plenty of measurement issues with the Q ratio and it has to exclude the financial stocks because of their odd balance sheets. But the ratio was used by Andrew Smithers and Steven Wright in their book Valuing Wall Street, which correctly announced that US shares were overvalued just as Wall Street was peaking in 2000. The two ratios are shown in terms of the deviation from their long-term geometric average. On this basis, the two measures suggest the market is 76%-80% overvalued."

3) Climbing A Wall Of Complacency by Doug Kass

Markets are supposed to climb a "Wall of Worry."  Since 2009, there have been plenty of things to worry about from the Eurozone crisis to the debt ceiling debates and threats of a U.S. default.  However, that has changed as Doug Kass points out:

"• Mr. Market has climbed a wall of complacency.

 •There is a strong consensus about nearly every asset class.

 • Historically stock markets are often unkind to consensus and to the changing of the Fed.

 • Reward vs. risk has deteriorated for the U.S. stock market

 • Beware: Risk happens fast.

It has been nearly five years since the Great Recession and the ensuing generational bottom in the U.S. stock market.

The S&P 500 has risen from 666 to almost 1850. At 58 months, the current cyclical bull market advance is the second longest on record and is quickly approaching the 60-month expansion that occurred from 1982 to 1987."

4) What Will Trigger The Next Correction by Robert Seawright

Robert Seawright recently made a very interesting point about what will trigger the next correction.  This is something that I have discussed many times in the past, both on the daily radio program and in the newsletter, which is that we simply will not know until after the fact.  Rather it was 1929, 1972, 1987, 2000 or 2007 the trigger that caused the crash was only obvious in hindsight.  At the peak of the market everything looks just fine...until it isn't.

"I considered what obvious catalysts might stem the tide of higher equities and saw none. While it was already clear to me that market obstacles need not be foreseeable in advance (think Donald Rumsfeld’s famous “unknown unknowns”), that lack was still a significant factor in my preliminary thinking. Other than the unforeseeable — which seemed limited to me somehow — it looked like clear sailing ahead, despite high market valuations and the need for some correction to clean things out. That is, it looked like clear sailing until I remembered Black Monday: October 19, 1987. Coverage by The Wall Street Journal of that day began simply and powerfully. 'The stock market crashed yesterday.'"

"In other words, the market collapse had no definitive (or even clear) trigger. The market dropped by almost a quarter for no obvious reason. And while it’s counterintuitive, that observation is wholly consistent with catastrophes of various sorts in the natural world and in society. Wildfires, fragile power grids, mismanaged telecommunication systems, global terrorist movements, migrating viruses, volatile markets and the weather are all complex systems that evolve to a state of criticality. Upon reaching the critical state, these systems then become subject to cascades, rapid down-turns in complexity from which they may recover but which will be experienced again repeatedly."

 5) The Profits Bubble by Chris Brightman

One of the biggest concerns that I have currently has been the very elevated level of corporate profits.  Profits have been driven by accounting magic rather than increases to the top line of revenue.  Chris summed this up well:

"Profits are dangerously elevated by all reasonable measures. S&P 500 Index real earnings per share are far above their long-term historical trend. Industry profit margins are at or near all-time highs. Corporate profits, both as a percentage of GDP and relative to labor income, are at or near record levels. The dramatic rise in income inequality is a direct consequence of this spectacular reallocation of income to capital and away from labor."

"Many of today's investors uncritically assume that the conditions they have known over the course of their professional careers must be normal. The idea that we may soon experience a multi-decade period of zero or negative growth in real earnings per share, taking the level of profits down to a lower share of national income, seems preposterous. Yet economic history has seen many examples of such a turn, including the 1880–1890s, the World Wars, the 1930s, and the 1970–1980s. In fact, almost every decade except the 1990s and 2000s saw a protracted profits slump. Some declines in profitability lasted most of a decade; others, longer!"

Chart Of The Week:  Income Inequality

Chris Brightman touched on the issue of income inequality in his profits study above.  This past week I showed this point specifically in the following chart on profits versus wages and employment.

"Those two charts also suggest that, despite hopes of continued profit growth, the ability to increase profits from suppressing employment and wages is both finite and likely nearer its end than the beginning.  In other words, what happens to corporate profit growth when there is an inability to extract profitability through cost cutting?"

The real issue is not "income inequality" but "productive inequality."  The solution to solving income disparity is by focusing on measures that increase productive capacity.

While the issue of income inequality is going to be the centerpiece of the upcoming State of the Union address, it is more about diverting attention away from the Affordable Care Act than economic reality. 

Political Calculations devolved the argument of income inequality quite well:

"Income inequality theory is a lot like ancient astronaut theory, in that in order to believe in it, you have to disregard a lot of evidence to the contrary."