by Vernon Moret on Mar 2, 2022
I am going to list a number of my concerns and try not to make this too technical. But first let me point out that being cautious about the market has made me and the other advisors I communicate with very quick to sell positions that are not working. This tactic and the volatility of the markets led us to getting whipsawed in the second half of the year, particularly in December. You may recall that right after Thanksgiving the first case of Omicron was reported in the U.S. The market sold off sharply forcing us out of a number of positions. And the Federal Reserve started talking about raising interest rates and that further rattled the market. However, the major indices did manage to stage a comeback later in the month and we were not fully invested after getting out of some of the positions so we did not benefit from the rebound – which has since evaporated. My friend Don Creech who provides a wealth of information re the markets reminds us constantly that our first responsibility is to preserve capital! He pointed out that our clients have accumulated money for their retirement and are not in a position to suffer large losses. We may underperform the major indices at times, but we must strive to preserve capital. Note: the closing price of the S&P 500 on 01/21/22 is only a few points above the closing prices on 07/12/21. Six months of no returns and a lot of volatility!
That said, I am going to review my concerns about what I believe is a very overvalued stock market. Keep in mind, there are basically 2 ways to correct overvaluation. One is for earnings to catch up which means the market would be choppy and move sideways. The other is for the prices to come down to a more reasonable valuation. That is the scenario that I am concerned about.
As to valuations, let’s start with the Buffett indicator. You may have heard of the legendary investor, Warren Buffett. He came up with the idea of looking at the ratio of corporate equities to United States GDP (Gross Domestic Product which is the total value of goods and services produced within the U.S. in one year). You would think that the value of the stock market would track GDP. One way to measure this ratio is to compare the value of the Wilshire 5000 Total Market Index (the broadest stock market index of publicly traded companies) to the U.S. GDP. This measurement goes back to 1971 and it has often been around 100%. In 2007 before the Financial Collapse, it peaked at 105.0%. In 2000 at the height of the tech bubble it was 136.9%. It recently hit 197.9%! (Source: Advisor Perspectives; February 2022).
Another measurement is the CAPE ratio. CAPE stand for Cyclically Adjusted Price Earnings Ratio. In English, this is a long-term average of the stock market’s price to underlying earnings. It recently hit 39.6. Now that in and of itself is meaningless unless you compare it to other levels and the only time the current level was exceeded was at the top of the Tech Bubble in 2000. And that did not end well.
I went back and looked at the change in the S&P 500 and U.S. GDP since the end of 2009. U.S. GDP has increased 40% since then, yet the S&P 500 has gone up 3.4 times in value! Shouldn’t the stock market reflect the growth in the economy? Not lately. I recently read an article in Advisor Perspectives that showed a chart from Pavilion Global on the source of the S&P 500’s gain from 2011 – 2021. 31.4% from earnings (about the gain in U.S. GDP) and 7.1% from dividends. So that is 38.5% from true fundamental sources. The rest? 21% from P/E expansion (think CAPE and Buffett indicator) and 40.5% from stock buybacks!
I am absolutely convinced from everything I have read that the P/E expansion and stock buybacks are due to the Federal Reserve’s massive money printing and extremely and artificially low interest rates.
But wait, there’s more! (As they say on late night TV.)
Fewer and fewer stocks were participating in the market gains over the last year. Goldman Sachs calculated that 51% of the gain in the S&P 500 since April of last year came from just 5 stocks: Microsoft, Google, Apple, Nvidia & Tesla. Another way to look at market participation is the percentage of stocks that are trading about their 200-day moving average (that is simply the average of the closing prices of a stock for the last 200 trading days). In a healthy market, you would like to see the majority of stocks above that average as that means they are in a positive trend. At the beginning of 2021, 75% of stocks were above their 200-day average. At the end of 2021 only 43% were above that average and at the close of 02/28/2022 only 31% were. (TC2000 Stock Charting Software).
Now high valuations in and of itself do not lead to market corrections. But they do make us very alert to changes in the market. So, what could go wrong? If you believe that the Federal Reserve’s policies have driven this market higher, then a change in policy could be meaningful. And it looks like the Fed has finally caught on to the idea that inflation is real and not temporary. They are now talking about raising interest rates and reducing their balance sheet which would have the effect of reducing the money supply. And this is coming much sooner than the market anticipated. Since I believe this market has thrived on low interest rates and loose money, a change in this policy could have serious repercussions.
A couple of more points. There is no doubt that the massive stimulus programs from the Federal Government fueled a lot of spending that impacted the economy. Those programs are now ending. Another concern is how much debt has fueled the stock market. Margin loans are a way of borrowing money on the value of your stock to buy more stock. Recently the level of margin loans hit an all-time record. And there is a very strong correlation between the level of margin debt and the changes in the S&P 500. The problem with margin is that if your stocks decline then the brokerage firm that loaned the money will want you to put more money in the account or sell some of the stocks in your account. Many investors don’t have extra money to put into their account so they have to sell stocks. That puts downward pressure on stock prices which can lead to more margin calls which can lead to more selling.
The Russian invasion of Ukraine has created more uncertainty and volatility. And there is no way of knowing at this time how this will turn out and what the repercussions will be. But the issues I have raised will still be with us and risk management will be more important than ever.