“Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation.”
– John Maynard Keynes.
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July 12, 2024 — The stock market has done it again — made a new all-time high.
And despite a sharp drop on Thursday led by tech, investors are quite willing to buy the dip, even if it’s just a few percentage points.
That suggests that “animal spirits” – to borrow a turn of phrase from John Maynard Keynes, are at work. Keynes is best known as an economist, which is unfortunate. His view of government stimulation of the economy has been used to justify all sorts of wasteful and inflationary projects.
But as an investor? Keynes is a prototype value investor. After taking a hit during the Crash of 1929, Keynes took a value approach, investing heavily in discounted debts of utility companies and other safe investments.
He learned how to handily outperform the market by taking a more cautious approach.
No doubt after the next crash, many investors will want to do the same thing. But we feel it’s better to lighten up ahead of a crash. That will take the worst sting out of the occasional (and necessary) market decline.
Even better, market crashes create great valuations in great companies. But the deals don’t last long. That’s why it’s best to sit in cash ahead of time. And at today’s interest rates, sitting in cash is hardly the penalty it was from 2009-2020.
Today, we’ll look at the latest viewpoint of Global Markets Investor. He’s a friend of The Grey Swan Investment Fraternity, and asks the very simple question we should always ask when stocks hit all time highs. Is it time to cash out at least some profits?
Fair warning: This article is longer than usual. But please, take some time over the weekend to really study these charts.
It may help you understand the truth behind today’s markets. And help you to prepare for the next market downturn, which may not take much to kick off. Enjoy ~~ Addison
CONTINUED BELOW…
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CONTINUED…
Is the U.S. Stock Market In a Bubble?
Global Markets Investor
Over the last several years, the U.S. stock market has experienced an incredible run. This is despite that, in the meantime, it has also seen a bear market in 2022.
Since the 2020 Pandemic Crash low, the Nasdaq 100 has rallied by 188%, the S&P 500 by 150%, small-cap stocks by 124% and the Dow Jones Industrial Average by 114%.
Additionally, year-to-date, these indexes are up 22%, 18%, 6%, and 5%, respectively.
As you can see, the stock market has been almost entirely driven by U.S. technology stocks. Notably, 40% of the S&P 500 stocks are still down year-to-date.
Given this incredible run and deteriorating economic prospects…Is the U.S. stock market overvalued?
Is the U.S. stock market in a bubble similar to the 1999 Dot-Com?
Answers to these questions are especially important for medium and long-term investors.
As I have written on multiple occasions, the U.S. economy has slowed and most of the data reported has been substantially below expectations.
This has created a historic divergence between Economic Surprise Indexes and the stock market valuations.
The Bloomberg Economic Surprise Index measures whether economic data has been coming in above or below average Wall Street estimates. For example, if economic growth is estimated to be 2% year-over-year and the final data comes at 1% it makes the index fall.
Recently, the gauge plummeted to the lowest level in 9 years, meaning most of the US data in the last few months has disappointed.
In the past several years, the U.S. stock market valuations (forward P/E Ratio) have been moving roughly in line with the Economic Surprise index. This has been mostly fueled by stock prices and to a lesser extent by earnings (P/E = price divided by earnings).
Recently, however, those two metrics significantly diverged as the S&P 500 has been driven by only a handful of stocks.
This cannot last forever, and the gap will eventually close in the next few months as the reality kicks in.
The same phenomena have been observed between the Nasdaq 100 index valuations (forward P/E Ratio) and the Citi Economic Surprise Index – a similar indicator to Bloomberg’s gauge.
In summary, we can see that the market has clearly gone too far and this is a notable warning sign for the U.S. stock market investors.
U.S. Technology Stocks Valuations
Let’s have a closer assessment now of the Big-Tech which in the past 2 years has been driven by the AI frenzy after ChatGPT launch on November 30, 2022.
The forward P/E ratio of AI stocks has recently hit 33x, just 1x below an all-time high recorded in 2023.
To put this into perspective, the S&P 500 is trading at 22x, which gives an 11x gap in valuation, the highest since June 2023 when the gap was 15x.
Notably, the discrepancy is ~4 TIMES larger than it was in December 2022 after the market was in the first weeks of a recovery from the bear market.
Since then, NVIDIA, AMD, and Taiwan Semiconductor Manufacturing have rallied by a whopping 677%, 155%, and 130%, respectively.
In effect, NVIDIA’s share price has materially diverged from its estimated earnings.
This suggests that the price should revert to the mean (earnings) to be fairly valued.
Digging further, we can also see that mega-cap tech stocks’ valuations are the largest ever relative to their revenues.
The price-to-sales ratio (P/S) of Amazon, Apple, Google, Meta, Microsoft, Netflix, NVIDIA, and Tesla combined has reached 7.4x, the highest in history.
The ratio has almost doubled in 1.5 years and is even higher than in 2021.
In other words, prices have increased at a much faster pace than the estimated sales growth. The graph below presents the price performance of these mega-cap companies in 2024.
Overall, the entire technology sector’s P/E ratio is at 31x, the most since the 2000 Dot-Com Bubble burst and trades at 10x premium to the S&P 500 P/E of 21x.
This certainly should warrant some cautiousness as even before the 2022 bear market the forward P/E was 29x.
How Is the S&P 500 Valued?
The S&P 500 currently trades at 21x forward earnings, which is above its 5-year average of 19x and the 10-year average of 18x, suggesting stocks are overvalued versus the past but not that extreme. We have to keep in mind, however, that these averages do not cover the periods of elevated valuations recorded in the 1990s.
Therefore, when we analyze this in more detail the picture looks less bright. S&P 500 forward P/E ratio of 21x is the 2nd largest since the 2000 Dot-Com bubble burst and is 3x above the median forward P/E ratio of 18, the widest gap since the Dot-Com Bubble.
It means that something is cracking under the surface of the S&P 500 index. That could explain another historical phenomenon.
The 3-month correlation between S&P 500 returns and the number of S&P 500 stocks advancing dropped to the lowest on record. It means that the number of stocks driving gains is the smallest ever.
In other words, only several stocks have been advancing driving higher the multiples (P/E) whereas most of the S&P 500 companies have been either declining or barely increasing. This is well explained by the below chart.
Magnificent 7 (Amazon, Apple, Google, Meta, Microsoft, NVIDIA, and Tesla combined) was up 51% year-to-date through Wednesday and over 40% since April.
At the same time, the S&P 500 was up 18% whereas the equal-weighted S&P 500 increased by only 4%.
As a result of such an unequal stock market rally, the forward Price to Earnings (P/E) ratio of the top 10 stocks in the S&P 500 combined was 27x at the end of May, the 2nd highest in at least 3 decades.
The only period when the ratio was higher happened before the COVID-19 crash.
To put it differently, the top 10 stocks valuations are higher than during the 2000 Dot-Com Bubble. Using a historical analogy it can be said that the top 10 stocks are in a market bubble.
Summary:
Is the U.S. stock market overvalued? The above analysis says yes, it is.
Is the U.S. stock market in a bubble? Probably, not. But we can certainly claim that it is in a concentration bubble which poses a substantial risk for the entire market. Most of the S&P 500 gains have been driven by only 10 stocks, as well as valuations that have never been seen before. If those stocks start to fall, it will likely drag the entire market down.
The weight of the top 10 stocks in the S&P 500 has spiked to ~34%, the most in the entire history. At the same time, the market cap of the largest stock in the S&P 500 relative to the 75th percentile stock is 770x bigger. This is even higher than in the 1920s.
As a gentle reminder, in 2000 when the Dot-Com bubble burst U.S. technology stocks needed more than 15 years to come back to breakeven if someone bought at the top.
However, even if the market abruptly falls I do not think we will have to wait another 15 years to breakeven. This is because we now live in the era of massive government deficits and the Fed’s Quantitative Easing, in other words, money printing. If the economy enters a recession and the stock market declines then authorities will do everything to prop this up as they did in 2009-2010 and 2020-2021.
Meanwhile, a record number of U.S. households own stocks, asset managers are the most bullish in decades and funds have invested the most in stocks in over a decade.
In conclusion, valuations are stretched, the economy is rapidly deteriorating and the stock market sentiment among people and funds is so euphoric. This is a time to play defensive, and I do. It may change around the U.S. presidential election date or after, and I will certainly inform you about that.
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So it goes,
Addison Wiggin
Founder, The Wiggin Sessions
P.S. How did we get here? An alternative view of the financial, economic, and political history of the United States from Demise of the Dollar through Financial Reckoning Day and on to Empire of Debt— all three books are available in their third post-pandemic editions.
(Or… simply pre-order Empire of Debt: We Came, We Saw, We Borrowed, now available at Amazon and Barnes & Noble or if you prefer one of these sites:Bookshop.org; Books-A-Million; or Target.)
Please send your comments, reactions, opprobrium, vitriol and praise to: addison@greyswanfraternity.com
