By Don Kaufman
The need to be in the market is reaching epic proportions. The extreme speculation and lack of volatility make me nervous even though I’m optimistic about the fundamentals of the economy and corporate earnings.
As you can see in the chart below, the cash position in Charles Schwab’s (NYSE:SCHW) clients’ accounts is at a historic low. It’s lower than both previous cycle peaks. That’s likely being caused by low interest rates and the lack of a recession in almost 9 years.
The question is if this means stocks are the most overvalued they have been in 22 years. I would say no in the current scenario.
If interest rates were to spike, then I would say stocks are overvalued, but before I could utter those words, stocks would crater.
It’s not a great time to be buying when cash positions are at their record lows and sentiment is near a record high for consumers and investors.
Not only do investors have little cash in their accounts, but also consumers have a small amount of cash saved. As you can see, the disposable savings rate in November 2017 was 2.9% which is near the lowest rate ever.
The only lower savings rate was in 2005 right before the housing bust. This low cash rate makes sense because credit card debt is at a record high and the unemployment rate is very low. It makes sense to save when you have a job, but what catalyzes savings is the fear that you’ll lose your job because your friend lost his.
Debt servicing will only be a problem if interest rates go up or if the job market weakens. Those two things happening are inevitable, but timing their change is everything.
Interest rates look they will increase modestly in 2018, but nothing that would cause a crash. The labor market now looks as good as it can look, as some firms are even doling out bonuses because of the tax cut. AT&T is handing out $1,000 bonuses to its employees.
Comparing 2016 To 1929
The point of the comparison between the 1920s and the 2010s isn’t to say that the economy is about to go into a Great Depression in a couple years.
We’re looking at the earnings results used in the Shiller PE Ratio which is screaming that stocks are overvalued. Investors claiming that the Shiller PE is too high because 2008 earnings are included are missing the point.
The Shiller PE is a cyclically adjusted multiple, meaning it’s supposed to include recessionary earnings periods to capture the whole business cycle. The longest expansion ever was 10 years, so there was a short period where the Shiller PE didn’t include a recession.
If the economy keeps growing so that the 2008 earnings aren’t included, it would defeat the purpose of the Shiller PE and possibly encourage someone to start using more years of earnings data in the multiple.
It’s already obvious that the 1920s period and the 2010s period will be different because 2017 is about to have record earnings.
If the estimates are met, 2017 will have $114.71 in earnings. That would be 562% growth from 2008, meaning the total growth would be 3% more than the 1920s and the length would be one year longer. The Shiller PE is about where it was in September 1929, so a few more months of rallying will also separate it from the 1920s in that aspect.
The key point this chart emphasizes is that in a comparable scenario a weak earnings year is included in the data. These two cycles are apples to apples, meaning stocks are about to be more overvalued than in 1929. That’s meaningless for 2018 returns, but meaningful for the next 10 years of returns.
Will equities rise at the end of the cycle?
The issue we discuss constantly because it is so important to this market is how big gains can occur at the end of the business cycle even after economic results start to turn. You can see that exemplified by the fact that earnings peaked in 2006, but stocks peaked in 2007.
The bull market is like a snowball that picks up speed and size rolling down a mountain. A few weak reports can’t stop it. It only stops after the economic slowdown is obvious.
The chart below is great evidence of this bifurcation. The red line shows confidence in global equities while the black line shows the confidence in improvements in the business cycle. Business confidence in future improvements to growth is down, while investors are very optimistic.
The fact that some investors are bearish simply because the expansion has been long is a great way to make money in the short term if the cycle continues. However, at some point, it will end which is what this chart is showing.
Low housing inventory
The chart below shows housing inventory. At first glance, it looks like the housing market is poised to move higher because inventory is so low.
While that may be the case in some areas, it’s best to remove the housing bubble in the 2000s. It distorts the chart. The inventories as a percentage of total houses soared in 2007 as the housing market was crashing. The current level of inventory is comparable to the late 1990s and early 2000s.
While the population is bigger now, the homeownership rate is smaller, meaning the inventory rate isn’t extremely low as it initially seems. I’m not saying we’re not in a seller’s market. I’m just clarifying the chart.
In 2017, stocks were expensive, but there wasn’t a classic late-cycle setup since inflation wasn’t increasing. The rising rate environment makes 2018 the late cycle year analysts have been discussing for years.
Just because the business cycle has been going on for a while doesn’t mean we’re at the end of the cycle. The specs need to be met, namely rising inflation, peaking demand, rising year-over-year unemployment, excessive speculation in stocks, a Fed that’s hiking, and an inverted yield curve. The year 2018 could be like 2007 and 1929.
I’m not saying a dramatic crash is coming, but the end of the bull market might arrive in the next two years.
Originally published on MoneyShow.com