Kass: Are Valuations Peaking?

This column originally appeared on Real Money Pro at 7:47 a.m. EDT on May 22.

NEW YORK ( Real Money) --

"Led by declines in production-related indicators, the Chicago Fed National Activity Index (CFNAI) decreased to -0.53 in April from -0.23 in March. Three of the four broad categories of indicators that make up the index decreased from March, and none of the categories made a positive contribution to the index in April."

-- Chicago Fed's National Activity Index

Monday's "Mr. Market Sings a Happy Song" addressed the disconnect between economic reality (GDP and profits) and a near-parabolic move in the U.S. stock market.

This terrific chart from Zero Hedge underscores the disconnect by comparing the S&P 500's price with its cash flow.

In support of my view (which has been, with the benefit of hindsight, the wrong market focus) and as promised, I wanted to take a deeper dive into Monday's release of the Federal Reserve Bank of Chicago's Index of National Economic Activity.

This economic series is published monthly. It is a broad-based and accurate index that includes 85 different and timely measures of U.S. economic activity. As such, it is a good representation of near-term economic activity in our nation.

The April index was -0.53 compared to -0.23 in the prior month and against a long-term average of zero. The current reading is unambiguous -- the domestic economy is slowing now, and economic activity is growing below its trend-line rate.

This reading is confirmed by another widely followed indicator Citigroup's U.S. Economic Surprise Index , which now stands at -18 -- the third-lowest reading in 2013 and down from +40 at this year's beginning.

Over there, the G-10 Economic Surprise Index is now at -29, which is also the third-lowest print of the year and compares against +12 on Jan. 1, 2013.

In other words, here and abroad, the current economic data is disappointing relative to the consensus expectations.

A slowing global economy that is disappointing relative to consensus has produced and will likely continue to generate relatively weak top-line sales growth. In first quarter 2013, S&P revenue (excluding financials) was only slightly above zero, and guidance for about 2% growth is very negative as it relates to profits growth.

There is little debate that the disconnect between fundamentals of GDP, corporate sales and profits (weak and disappointing) and share prices (strong and euphoric) has widened in recent weeks. Nor is there much debate that valuations (P/E ratios) are climbing due to global monetary easing and there appears to be little alternative to equities from low-yielding bonds.

This means that the billion-dollar question is to figure out whether the market's P/E can continue to expand or whether it is peaking.

The S&P 500 closed on Tuesday at 1670. Based on earnings of about $104 a share, the S&P now trades at 16x forward earnings vs. a long-term average of 15x over the past five decades.

When S&P profits are about to peak (my baseline expectation), however, the forward P/E multiple has averaged closer to 14.5x.

I have argued (and continue to advance the notion from an analytical standpoint) that given that profit margins are near 58-year highs and well above (by nearly 75%) their historic trend line and in light of the tepid top-line growth anticipated (mentioned previously), indeed S&P profits are peak-like today.

In conclusion, the market's valuation (P/E ratio) appears very stretched given historical earnings relationships, peak-like S&P profits and vulnerable profit margins.

While my outlook has been wrong-footed since February, I continue to be of the view that the market's risk/reward is unattractive at current prices.

At the time of publication, Kass and/or his funds were short SPY, although holdings can change at any time.

Doug Kass is the president of Seabreeze Partners Management Inc. Under no circumstances does this information represent a recommendation to buy, sell or hold any security.

More from Investing

Street Stats: The Mid-Term Elections May Be a Rollercoaster Ride for Investors

Street Stats: The Mid-Term Elections May Be a Rollercoaster Ride for Investors

Trump's Oil Tweets Ruining the Stock Market's Rebound?

Trump's Oil Tweets Ruining the Stock Market's Rebound?

A BJ's Wholesale IPO Is Logical Next Step

A BJ's Wholesale IPO Is Logical Next Step

Tesla Investor Pushing for More Board Changes

Tesla Investor Pushing for More Board Changes

What You Need to Know About Facebook and Europe's New Privacy Rules

What You Need to Know About Facebook and Europe's New Privacy Rules