U.S. Stock Market: Why You Should Move With Caution Despite Upside Potential
Summary
- Without much doubt, the stock market in the United States is extremely overvalued.
- However, when looking at the bond market, housing, initial unemployment claims, consumer sentiment or the ISM purchasing manager index, a recession seems not likely in 2022.
- Nevertheless, we should move with extreme caution - even if stocks should move higher in 2022, a huge crash will occur.
Nikada/E+ via Getty Images
In December 2019, I published an article in which I argued, that the economy was completely detached from the stock market - especially in the United States. About 2.5 months later, the brutal 5-week crash and recession followed. I am referring to this article not because I predicted the stock market crash and recession (I published articles before warning about high stock market valuations), but due to the structure of this article. I used several metrics and in the following article I want to use the same metrics again and try to determine where we are in the cycle.
Valuation
About 2 years after the above-mentioned article, the stock market is even more detached from the economy as many stocks are trading for even higher prices, but the economy (or at least several sectors) must deal with the consequences of the last recession. And even when acknowledging, that we are always dealing with probabilities and should avoid words like "certain" or "without any doubt", I am as certain as I can be, that the US stock market is extremely overvalued.
And with thousands of different metrics we can use, it seems easy to find those supporting our thesis and we always must be careful not to become victims of the confirmation bias. But one of the best metrics - in my opinion - is still the CAPE ratio and with a ratio of 38.4 we are trading at one of the highest ratios during the last 150 years. Aside from the Dotcom bubble, no other bull market - including the one before the Great Depression and the Great Financial Crisis - saw higher CAPE ratios.
(Source: Advisor Perspectives)
And one can always argue that it could be worse by referring to the Dotcom bubble, which saw a CAPE ratio of 44.2 during the March 2000 peak. But that is like miraculously surviving a car crash with 150mp/h and then intentionally trying to crash again with 140mp/h. Knowing that a crash with 50mp/h could already be deadly, nobody would deny that a crash with 140mp/h is dangerous just because one survived a 150mp/h crash once. And nobody should consider the stock market being cheap just because out of 150 years of data, there are a few months in which we saw a higher CAPE ratio - completely ignoring that in 149 years the CAPE ratio was much lower.
Additionally, we can look at the so-called "Buffett Indicator" which is comparing corporate equities to the GDP. Right now, corporate equities are trading for 220.6% of the GDP. And while we could argue in 2020, that the GDP was exceptionally low and leading to a distorted picture, we can't make this argument anymore. 
(Source: Advisor Perspectives)
Some are making the argument, that the Buffett Indicator is worthless as US companies are generating more and more revenue overseas and the GDP is not the best denominator. And even when following that line of reasoning, we still must state that we are trading way above the exponential regression line. And especially the steep increase in the last few quarters is worrisome - the ratio is popping up like a champagne cork.
Additionally, we can also look at some ratios John Hussman is using. Hussman for example is looking at the nonfinancial market capitalization compared to nonfinancial corporate gross-value added including estimated foreign revenue. And as foreign revenue is included, this is also a strong argument against the critic which is brought forward against the Buffett Indicator.
(Source: John Hussman: When bubble meets trouble)
And we can always find arguments, why some indicators might not be perfect or present a distorted picture. But as so many different indicators are pointing towards overvaluation, we must accept that reality - a reality Jeremy Grantham is also pointing out:
And, of course, they're always extremely overpriced by average historical standards. And this one, there are a few people who would still argue that 2000 was higher, but most of the data suggest that this is the new American record or highest-priced stocks in history. And then, there's the most important thing of all, which is crazy behavior, the kind of meme stock, high participation by individuals, which has kind of tripled in 18 months to an abnormally high level, enormous trading volume in penny stocks, enormous trading volume in options, and huge margin levels, peak borrowing of all kinds.
And once again, we can find several great investors arguing we are not in a bubble - the most famous right now might be Cathie Woods, who has recently predicted a CAGR between 30% and 40% for her "strategies" (whatever that means) in the next few years. And predicting an annual return of 40% is probably as bullish as one can get.
Bubble Does Not Equal Crash
But as I have learned (painfully) in the last few years, an overvalued stock market by itself (even when looking at such extremes as right now) is no reason for an immanent crash. And as a famous quote, which is often ascribed to John Maynard Keynes but probably stems from A. Gary Shilling, states: The market can remain irrational longer than you can remain solvent.
Extreme valuations are only telling us, that the discrepancy between stock prices and the fundamental economy must be resolved (usually by a crash), but don't tell us when this will happen. In my opinion, predicting and timing a stock market crash is rather difficult, but there are some early warning signs and indicators we can pay attention to. And like we cannot just look at valuation, we cannot just look at a single indicator telling us when the stock market might crash. Instead, we must look at several different aspects simultaneously to get a clearer picture.
Bond Market
And while no single indicator might tell us exactly what will happen, the bond market (and yield curve) has been a pretty good early warning indicator in the past (some short articles about this can be found here, here and here). When looking at the last few decades, an inverted yield curve (measured by the difference between the 10-year yield and either the 2-year yield or the 3-month yield) always occurred before the next recession. And what is even more important, we have only very few false signals and hence we can call that indicator very reliable.
(Source: FRED)
However, when looking at the last few months, we should not be worried right now. When looking at the 10-year vs. 2-year treasury yield (blue line) we see a decline again and it is possible, that it inverts (gets below zero) in the next few months, but right now, the yield curve is not really sending a warning sign and a recession in 2022 is not likely (but one could happen in 2023).
(Source: FRED)
The yield curve is an extremely good indicator in my opinion, but it is not the only one we should pay attention to - a second indicator could be the housing market.
Housing
13 years have passed since the Great Financial Crisis and people seem to forget again. But especially in the years after the Financial Crisis, the housing market was of particular interest as it was one of the major reasons for the Great Financial Crisis. And when looking at the new privately-owned housing units started, we saw an extremely steep and long-lasting decline during the Great Financial Crisis. But the number also declined previously to most other recessions.
(Source: FRED)
But right now, I don't see a slowdown or any hints indicating, that a recession might be upon us.
ISM Purchasing Manager Index
Another indicator, that has also been a pretty good warning sign in the past, is the United States ISM Purchasing Manager Index. And while the index fell in the quarters before 2020 (and was therefore indicating the following recession), the index improved over the last few quarters and is now at the highest level since the beginning of the 1980s. 
(Source: Trading Economics)
And like the yield curve and housing, the ISM Purchasing Manager Index is also not indicating a recession right now.
Labor Market: Initial Claims
During a recession, unemployment is also rising sharply, and initial claims would be the best indicator to show troubles ahead of most other labor statistics. When looking at the initial claims in the last few months, we see constantly declining numbers and we can hardly argue that initial claims are indicating a recession or troubles ahead.
(Source: FRED)
But the different labor market indicators (including initial claims) are not the best early warning indicators as initial claims are sometimes only increasing a few months before a recession and sometimes the initial claims are increasing only slightly making the risk of false signals rather high.
Consumer Sentiment
One last indicator we are looking at is the consumer sentiment measured by the University of Michigan. And like the other indicators, consumer sentiment can indicate a recession beforehand - in this case by a declining consumer sentiment.
(Source: FRED)
And consumer sentiment dropped steeply in the recent past and that could be a warning sign, that a recession might be upon us. However - as we can see by looking at the last few decades - that indicator is not really sending a clear signal before a recession, and it was also sending several false signals during the last few decades.
The Picture
When summing up, we have a stock market that is trading for extreme valuation metrics and is screaming, is begging for a huge crash and for stock prices to come in line with fundamentals again. Additionally, we have a consumer sentiment, which could indicate a recession in the coming months. But when looking at the housing market, the labor market (initial claims), the ISM Purchasing Manager Index or the yield curve, I find it difficult to argue, that a recession will occur within the next few months. And as I have stated above, we should pay attention to several different indicators and not just focus on one or two.
Move With Caution
And although I don't see a huge stock market crash in the next few quarters, I am familiar with the concept of black swans and I know about dozens of cognitive biases, that can distort and blur our vision and interpretation of numbers and lead us to false conclusions. I also like to claim, that I have understood that absolute certainty does not exist, and we are always dealing with different scenarios and different probabilities we can ascribe to these scenarios.
And right now, I would assign the following scenario a rather high probability: The stock market will continue to move higher in the next few months although it doesn't make any sense from a fundamental point of view. But in a few quarters from now, the stock market will start to resolve that extreme detachment from the fundamental reality, and we will see an extreme bear market.
And I won't stop buying stocks, but I will move with extreme caution like I have already done in the last few years. This means I will only buy stocks when I think I have identified a bargain.
Conclusion
Without any doubt, we are living in extraordinary times right now and as scientist or person looking at the situation with scientific curiosity, I find it extremely interesting, and it is a fascinating time we are living in as we can learn a lot. But as a person, who might be affected by extreme inflation or by stocks in the portfolio declining 60%, 70% or 80%, I would probably prefer to live in different times.
And let's be clear - I am not bullish about the stock market. I only think it is a possibility that the stock market will move higher over the next few months. But this is a dance on the volcano, and we are balancing on a knife-edge - and if you are not careful and think investing in the stock market by using leverage is a great opportunity you might lose everything.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.
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