U.S. Stock Market: At A Crossroads

Right now, the stock market might be at a crossroads once again, and we have to see if it is also at an inflection point. Since it became obvious that Joe Biden will be the next president of the United States, and Pfizer Inc. (PFE) and BioNTech SE (BNTX) as well as Moderna Inc. (MRNA) announced very promising results for a COVID-19 vaccine, the stock market rallied again and the S&P 500 (SPY) finished up 11.8% in November 2020 – the best monthly performance since 1987.

(Source: Pixabay)

Sentiment is as bullish as it can be, and investors don’t see anything else than a bright future ahead for the stock market. Nobody seems to care that we are still in a recession and COVID-19 cases are rising dramatically. Talking about valuation and investor sentiment seems completely absurd, as nobody seems to care about stock market valuations or the extreme sentiment any more. And therefore, we will do just that: talk about valuations and sentiment.

Sentiment: Bullish, bullish, bullish

The sentiment of market participants is as bullish as it can be. This is a feeling one gets by reading comments – for example here on Seeking Alpha – or reading articles and just listening to people. But aside from these rather subjective measures of sentiment, we can underpin these feelings by numbers. One number might be the CNN Fear & Greed Index, which is trying to measure investor sentiment in the United States. Right now, the index is at one of the most extreme levels in the last few years. This does not tell us that a correction must happen right away, but when looking at times where sentiment has been similar bullish – at the beginning of 2018, in the last summer of 2018 or at the beginning of 2020 – a steeper correction followed. Of course, the correction not always happened right away, and trying to time the market by using the Fear & Greed Index is a terrible idea. But it is a warning sign that should make us cautious right now.

(Source: CNN Fear and Greed Index)

SentimenTrader also posted a similar chart last week on Twitter (TWTR), which is underlining the extreme bullishness we are seeing right now. The fact that we are seeing the most extreme numbers since 2006 was commented on in the tweet with the simple phrase “excess of excesses”.

(Source: SentimenTrader via Twitter)

Two further aspects worth mentioning are, first of all, the number of stocks trading above the 200-day moving average. According to Barchart, 86% of stocks are trading above the 200-day moving average, which is the highest level for almost 10 years. Additionally, we can mention Jesse Felder, who pointed out that the Rydex Ratio is indicating a bullishness we did not see for almost 2 decades.

Valuation: Extreme, extreme, extreme

One can now call people like Jesse Felder perma bears, as he is one of those authors that regularly points out the extreme market valuation. But if we refrain from name-calling, valuation metrics are hard numbers. And although these numbers leave some room for interpretation, we can’t deny how extreme market valuations are right now. One of the best metrics for market valuations is the CAPE ratio introduced by Robert Shiller, which is about 33 right now. In the chart below, we can also see that the Real S&P Composite is trading 144% above its regression line, which is also indicating extreme overvaluation and extreme deviation from the mean.

(Source: Advisor Perspectives)

Instead of the CAPE ratio, which is including earnings from the last ten years, we can also look at the P/E ratio, which is only reflecting earnings from the last 12 months.

(Source: FactSet Earnings Insights)

And one might argue that the trailing 12-month P/E ratio is not a good metric to use, as it is including the weak numbers of the last two quarters and might not be representative of the great future ahead. I don’t agree with that argument, but even if I did, the chart using the forward earnings is not looking much better.

(Source: FactSet Earnings Insights)

We can also look at the heatmap by Finviz, which is showing a lot of red and is also indicating that the stock market is trading at extremely high P/E ratios.

(Source: Finviz)

I know that many people simply don’t care about market valuations or justify the current valuations by referring to the low interest rate. And I don’t want to dismiss the fact that low interest rates should have a positive effect on stock prices for several reasons. But what if interest rates start to go up again? We all know that interest rates actually don’t have to go up – the anticipation of higher interest rates is enough. And I am quite aware that the Fed is showing no intention of raising interest rates in the foreseeable future, but as a long-term investor, I am also interested what might happen in five years from now. Investing in stocks only because all the other assets apparently have even lower yields is dangerous, and it is also wrong. There are a lot of stocks for which we have to expect negative returns over the next ten years, and therefore, a 10-year bond might be the better alternative.

Assuming that valuations don’t count is just wrong. Investing is about the cash flows we can generate in the future from purchasing an asset. And that future cash flow has to be put in relation to the price we were paying when purchasing the asset – this is the yield of the investment. Stock investors can either be rewarded when part of the future cash flow is paid out as a dividend or the company can reinvest the generated cash and is therefore producing a higher future cash flow, which makes the business more valuable and leads to a higher stock price. But the generated cash matters. Let’s take Tesla (TSLA), for example. Analysts are expecting Tesla to generate $36 in total earnings over the next six years. Paying a price of $600 and only receiving $36 over the next six years leads to a yield of about 1% annually. Assuming Tesla can grow at 30% after the next six years for which we have estimates, it would take until 2035 before the we generated the invested amount in total earnings. If we assume 20%, it would take until 2038, and if we assume 10% growth, it would take until 2045 to generate the invested amount in earnings. And even 10% growth over decades is not as easy to achieve as many might assume.

Just back to normal

In this article, I left out fundamental data on purpose. I did not talk about the US GPD, which is still about 3.5% lower than in the fourth quarter of 2019 or the labor market with more than 700,000 people filing for unemployment insurance every single week (a number that is still higher than at any point during the Financial Crisis).

And when keeping these aspects in mind, it is especially puzzling to see a clear presidential vote leading to rising stock prices, or the hopes for an effective vaccine that might be approved and distributed in the coming months, leading to euphoria. It is puzzling because we have to remember one important aspect: the vaccine is a necessary requirement to get us back to “normal” again, it is a necessary requirement to get us to pre-crisis levels again. The vaccine will only enable us to live our lives again as we were used to before February 2020.

When reading comments and articles and when trying to interpret the investor sentiment, one must assume the vaccine is a miracle drug that will lead to high growth for the economy, a new bull market and a long-lasting boom for the economy. Don’t get me wrong – the vaccine is great news. But it is only helping us to get back to normal. In my opinion, stock market valuations were already at extreme levels in February 2020 – at a point where we had to expect the economy to slow down, but not to crash as hard as it did in the first half of 2020. In February 2020, the US stock market was trading at levels that did not justify the growth potential or the free cash flow companies will generate in the years to come. And suddenly a return to pre-crisis levels in 2021 should be a justification for much higher stock prices?

The economy is improving from rock bottom in the spring of 2020 (and it seems extremely unlikely that the economy will be hit again in a similar way), but we are nowhere close to pre-crisis levels. How can you justify even higher valuations than in February 2020 just by the hope that the “normal” world we knew before 2020 might be reinstated in 2021 again (and we won’t reach pre-crisis level in 2021)?

Sentiment is what counts

The answer is very simple: Investor sentiment. And while the answer might be simple, it still gets tricky. Over the long run, the stock market is a reflection of the economy. Over the long run, the economy and the stock market perform very similar. Meaning: Over the long run, fundamentals matter and the stock market will not “outperform” the fundamental development of the listed companies. But as long as investors don’t care about fundamentals, higher stock prices are possible over the short run.

It is possible, that the S&P 500 will continue to rise to 4k, 5k or even 6k. It would be madness at this point, but it is possible. Whatever will happen, one solid hypothesis remains: Everybody that is investing in the stock market right now will see almost no returns over the next few years. I don’t know if the stock market will first double and then crash 80%, if it will crash now or if it will remain at the current level for another decade. But I am as confident as I can be that this is not the beginning of a new bull market that will last for 7-10 years (typical duration of a bull market), as bull markets don’t start with CAPE ratios of 30 or higher. If you are certain that the S&P 500 will move to 4,000 or 5,000 over the next year or two, by all means, go for it. I don’t find any reasonable argument for such a bullish rally other than investors ignoring all fundamental data. And I am not skilled enough to read investor sentiment in such a way as to predict what will happen. I am familiar with Elliott Wave Theory (and, for example, the writings of Avi Gilburt on Seeking Alpha), but don’t feel confident to apply the theory to make tradeable predictions.

In 1999 and early 2000, investors ignored fundamentals for a very long time, and this can easily happen again. But I am not willing to bet on such a scenario. This means that I will more and more move to the sidelines – I don’t sell my stocks, but I will also buy only a very limited number of stocks at this point.

Conclusion

The question of whether the stock market is overvalued can’t be answer with scientific facts – the different metrics we can use leave enough room for interpretation, and depending on the metrics we use, the picture might vary. But calling the US stock market overvalued is at least a well-founded hypothesis. That does not mean that I will sell the stocks I am holding, and it also doesn’t mean I won’t add stock to my portfolio – if I will find undervalued stocks, I will buy. But right now, finding cheap stocks is the exception, not the rule.

When moving away from my long-term focus, the short-term picture might look different. The extremely bullish sentiment above is also indicating a correction in the next few weeks, as extremely bullish sentiment is usually a contra-indicator. But it is also possible that bullish sentiment will drive stock prices higher in the coming months (maybe after a correction has occurred). But over the next few years, investors who are buying right now will most likely lose a lot of money, or they will have to hold on to the investment for a long time (maybe one decade) for it to be profitable again. Over the long run, fundamentals will direct the stock market and not investor sentiment.

The answer might be different for short-term investments, but I am a long-term investor and don’t really care what the market will do in the next few weeks, and I also don’t want to profit from short-to-medium term swings. I want to buy stocks at prices that are reasonable and justify the cash flow the business can generate in the years to come. And for most stocks, that is simply not the case right now. And investing on the basis that there is always a greater fool somewhere could be dangerous and foolish. The last stages of a bull market are simply the organized search for the biggest fool – and someone will hold a bag of assets that are extremely overpriced. Don’t be that fool.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.