Stocks Are Still Overvalued - Does It Matter?

Summary

  • The "hopium" rally of the past couple days has been breathtaking as New York City gets slightly less bad news.
  • Stocks continue to be overvalued based on trailing earnings and are wildly overvalued for earnings in 2020 and 2021.
  • Who cares, though? The Fed has our back and maybe we can just print, baby, print our way to prosperity.
  • Traders appear to be pushing this stock market up looking for greater fools to be their bag holding suckers.
  • If you don't want to be the sucker again, trim your equity holdings, particularly those with high correlation to the S&P 500.
  • This idea was discussed in more depth with members of my private investing community, Margin of Safety Investing. Get started today »

Hope is what makes life bearable sometimes. In the face of mounting human tragedy, due to the coronavirus COVID-19 pandemic, the stock market is surging. May hope spring eternal.

With little reason to buy most stocks or the S&P 500 ETFs (SPY) (VOO) many investors are doing so anyway. They are buying despite the stock market still being overvalued against not only trailing earnings, but also forward earnings.

The "buy stocks" argument is that "it" is lower than before and the Federal Reserve is going to pump this baby up. Some semblance of that deep, historically based, rational analysis anyway (yes, that's facetious).

I took the time to outline in multiple articles and webinars why the stock market would crash in 2020. Coronavirus was merely the match that lit the fire. The fire is not out.

Multiple Valuation Measures Say Sell

Advisor Perspectives makes this easy to get and if you haven't seen it before, look it up, book mark it and visit every month. This is a combined measure of four different valuation measures.

Valuation

Of the four valuation measures, the one that's the most friendly suggests stocks can roughly halve from here. The others suggest a bigger correction could happen. Given the speed at which the corrections moved recently, do you want to chance being "just in time" with your portfolio pruning?

While this is not a great short-term signal, it should put into context where in the valuation world we are. The stock market is still trading above a second standard deviation valuation. That means expected returns for investors here for the next decade or so are not going to be very good.

The Buffett Indicator

Warren Buffett has said he believes that market cap to GDP "is probably the best single measure of where valuations stand at any given moment."

Here I borrow from GuruFocus which has the Buffett Indicator in real time:

Buffet Indicator 1 year

As you can see, the difference has narrowed between market cap and GDP. But, that chart is only one year. What does the long-term chart tell us below?

Buffett IndicatorWe can see that's a rarity for market cap to be so high compared to GDP and for such an extended period. What this means is that you are literally better off starting a company than buying stock in a similar company. Private equity and other investors do just that, creating companies to compete with the companies of the stocks many buy. More competition is not a good thing for a stock.

Something else to consider in the midst of Coronavirus: What are the odds that GDP doesn't come all the way back to 2019 levels by 2021 (we'll throw out 2020)? I think there's a zero chance that we see 2019 earnings in 2021. In fact, I do not think we see 2019 earnings again until the year after there's a vaccine for COVID-19. When will that be?

Valuation Math

Earnings for the S&P 500 in 2019 were $162.97 for essentially no improvement vs. 2018. According to Yardeni Research, and closely followed by many investment banks, S&P 500 earnings are tentatively estimated at $120 for 2020. Goldman Sachs put their earnings estimate for 2020 at $110.

My own proprietary estimate of earnings is at $91-92 for the year. This takes into account a slowdown I already believed was coming and COVID-19 on top. If we "open the economy" too soon and get a second wave of infections and deaths, earnings will close in on zero.

Let's set aside 2020 earnings because nobody really knows and take Yardeni's 2021 estimate of $150 in S&P 500 earnings. If we apply a 20 multiple, high by historical standards but reflective of today's easy money, then the S&P 500 should be roughly fairly valued at 3000. This is a best-case scenario in my opinion if the markets allow for rational price discovery at all.

I believe the reality is that earnings in 2021 are closer to $120-130 and that we are still struggling with many parts of the economy that matter to earnings. In that scenario, with optimism bidding up stocks less, say only to a normal 16 P/E then the S&P 500 fair value is 2080 at the high end.

From optimistic to pessimistic, the range of fair value for the S&P 500 in 2021 is 2080 to 3000. The S&P 500 is around 2700 now.

Technically Speaking

Stocks are weakly rebounding right now. What do I mean by that? Simply, the amount of money behind this rally is not substantial. Volume has not surged, indicating mass buying. Rather, it's a thinly-traded market with all the boat riders on the same side of the boat.

We can easily see that the rallies have lower volume lately.

SPYIn this weekly chart, we see that downward momentum is still fairly strong.

RSI is having a rally and is not overbought on the weekly, thus there could be a bit more rally and that's the scenario for getting back over 3000 on the S&P 500.

Now look at the four-hour chart (or half-day chart) as of mid afternoon on Tuesday. As I write this, it looks like the rally will lose steam Tuesday afternoon or early Wednesday.

SPY 4 hour

Why does a four-hour chart matter to a long-term investor? Against the weekly chart it should show you roughly where underlying weakness is and whether this "rally has legs."

Money flow measures started to dry up midday. That's indicative of the thin market I alluded to above. Finally, take a look at the bottom indicator. That's a measure of three exponential moving averages. While momentum is strongly up, it's also peaking, indicating an imminent turn, likely by next week or sooner.

Be A Seller Short-term

In my article Coronavirus Will Spur Much Deeper S&P 500 Correction, I pointed that: "People ignore valuations until there are no more greater fools, then something makes valuations suddenly matter."

I don't know what the exact news will be to make valuations matter again. I don't know if it will happen imminently or after a rise into the low 3000s on the S&P 500. I do know it will be soon enough.

I laid out in my annual outlook that 2020 would go from euphoria to despair. A reiterated in a New Year's Day article pointing out there would be massive stock market challenges in 2020. Maybe you listened, maybe you didn't. Maybe you didn't get the memos.

Here, I introduce a concept we have at Margin of Safety Investing. It's called "FOGYAK," which stands for "fear of getting your assets kicked." I think if you are chasing this market, you need to get some FOGYAK to offset your fear of missing out. What you should want, especially if the correction hurt, is to miss out on the next correction, because it's coming and the rebound will be slow and uneven.

When the time comes to invest, I urge you to make a significant asset allocation change to overweight the "smart everything world" and sell grandpa's slow and no-growth, high-debt, capital-intensive companies that are becoming zombies. More on that soon.

This article was an excerpt from Kirk Spano's Quarterly Outlook & Game Plan. Take a free trial to Margin of Safety Investing to get the entire report.

We called for investors to raise cash levels to 50-75% earlier this year. We are now planning to be buyers again and are recommending investors rotate into a better asset allocation designed for the 2020s.

This week, get Margin of Safety Investing for 50% off at only $249 your first year. Go to Kirk Spano's profile page and send a message with "half price" in the subject line to get your discount offer.

This article was written by

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I run a small boutique registered investment advisory and I have been managing money since the 1990s through several major market cycles. I have been widely syndicated and appear as an investing expert in the media.

I publish the Margin of Safety Investing letter on Seeking Alpha. You’ll find the Global Trends ETF portfolio there, growth & dividend stocks and the top option selling for retirement income service available to retail investors. 
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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.

Additional disclosure: On Friday mornings I hold a webinar for Seeking Alpha readers. See my blog for details. --- I own a Registered Investment, but publish separately from that entity for DIY investors. Any information, opinions, research or thoughts presented are not specific advice as I do not have full knowledge of your circumstances. All investors ought to take special care to consider risk, as all investments carry the potential for loss. Consulting an investment advisor might be in your best interest before proceeding on any trade or investment.

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