SPY: Historic Overvaluation Is Tinder Under The Stock Market

Summary

• The S&P 500 is overvalued by every valuation metric measured.
• While the market can remain irrational a long time, it cannot sustain record valuations forever.
• The question becomes is there a match to light the overvaluation tinder?
• The narrative is that the Fed is lighting the match, but trying to maintain a controlled burn, and there's other potential matches.
• Risk averse investors should be raising cash before a controlled burn turns into an out of control wildfire.
• This idea was discussed in more depth with members of my private investing community, Margin of Safety Investing. Learn More »

DNY59/E+ via Getty Images

In March of 2020, the Coronavirus Crash wiped out trillions in market cap from global investors. The subsequent Federal Reserve, Federal Government and global bailouts put trillions more right back on.

As I discussed BEFORE the crash, Coronavirus was just the match that lit the overvaluation tinder. Today, we are facing the same overvaluation in large cap stocks that we were facing as the New Year took hold in 2020 - in fact, valuations are worse.

The broader circumstances have obviously changed since early 2020 when the stock market was topping, but the core problem remains: historic stock overvaluation. It won't take much to cause a correction far more serious than the volatility we have seen the past few months.

Today, in the first of a series of articles on what I see coming in markets, we examine valuations.

Price To Earnings, Shiller & Q Ratio

Valuations

Advisor Perspectives

The P/E (price to earnings) ratio of the S&P 500 (NYSEARCA:SPY) (VOO) is at historic highs according to Crestmont Research. In their Q3 P/E review, they pointed out that "the current status of the stock market is positioned for substantially below-average long term returns.”

The cyclical 10-year P/E, otherwise known as Shiller P/E, is based on a normalized or smoothed earnings cycle. It is also near historic highs.

Finally, Tobin Q, or Q ratio, which measures the market value of a company divided by replacement value, is also near historic highs. Right now, Q ratio implies that valuations are bad for investors.

There is a flip side to Q ratio. Companies that issue shares are getting a deal for cash. Very few companies are taking advantage of that financing opportunity as shareholders hate the dilution, even if it helps the company wipe out debt or reduce operations expenses. About the only time shareholders support dilution is for M&A activity, which isn't always advisable financially.

Averaging the four measures shows a very concerning valuation picture. What we see is the most dramatic overvaluation in history. Of course this has come down a shade since the last measurement a couple weeks ago, but is still well above a 3rd standard deviation level, that is, outside the realm of normalcy.

Geometric Standard Deviation Average

Advisor Perspectives

The concept of "reversion to mean" is something that we hear about all the time. With the stock market, reversion, or regression, to trend is more relevant as it factors in the long-term uptrend in stocks.

The S&P 500 regression, a measure of what it would take to revert to the mean trend, is also still near record highs. It is implying a potential correction of around 40-50% - which is what GMO Chair Jeremy Grantham (Jeremy Grantham Doubles Down on Crash Call, Says Selloff Has Started) and Quantum Fund co-founder Jim Rogers (Jim Rogers: Next bear market will be ‘the worst in my lifetime’) are saying are likely to happen sooner than later.

Trend

Advisor Perspectives

Of course, markets can remain irrational a long time. There is no certainty as to "when" a correction or regression will happen.

Buffett Indicator

The Buffett Indicator is a measure of total stock market valuation versus GDP. Warren Buffett maintains that this is the single best measure for getting a broad look at value within the market.

High measures on the Buffett Indicator suggest relative overvaluation in the stock market versus the size of the economy as measured by GDP. Correspondingly, it also implies lower realized future returns.

The Wilshire 5000 also can serve as a proxy as well. As you can see, the two measures track very closely. The takeaway in either case is that it is often better to start a company than buy the stock of an existing company given the valuation of the stocks.

Buffett Indicator

Advisor Perspectives

Returns After Crashes

There have been four major bear markets since the Great Depression. Each recovery has been marked by a long-term rebound. However, the rebound off of the Great Recession was the first marked by massive quantitative easing by the Federal Reserve and other central banks.

Bear Market Recoveries

Advisor Perspectives

QE, which many see as money printing due to an expectation that most of the debt incurred to will never be repaid, only rolled perpetually, has likely prevented a depression.

The medicine though, as Buffett has echoed, also has side effects, the most prevalent being inflation.

Buffett On Inflation

Berkshire Hathaway

Of course it took several rounds of QE, a pandemic and then another massive wave of QE to help stimulate inflation that is also complicated by supply chain issues and OPEC "managing" oil prices higher. Along the way though, cheap liquidity, along with I believe ultra-low taxes on corporations, did cause inflation in stocks, real estate and collectibles.

The withdrawal of massive amounts of liquidity to markets by the Federal Reserve would seem to indicated some contraction on valuations makes sense.

Market Tops And Future Returns

The easiest way to understand what a recent rally means to the future is to consider things from a cyclical viewpoint. If we see a long-term bull market, there will usually be a corrective period that includes a bear market or two or three. If we see a severe corrective period, we then reload for a long bull secular bull market (which can have smaller cyclical corrective periods).

Expected Returns

Advisor Perspectives

What you see above is that after long bull markets, there is a corrective phase. It generally lasts much shorter than the bull market, but the price corrections can be severe.

30-50% corrections are not as uncommon as people want to believe. Once a decade is normal. Twice a decade is not unheard of. The dot.com bust and Great Recession happened in one decade and resulted in a near zero 10 year return.

Hussman

Advisor Perspectives

This reproduction of Hussman concept suggests that we are near the top of the market and that the next 10 years could be choppy with very low total returns for large caps the next decade.

Hussman's concept revolves around the cyclicality of markets. In short, a long bull period will be met with either a consolidation period or a bear market.

Consolidation periods are generally extended, like the period we saw from 2014 to 2016, while bear markets can happen in as quickly as a couple months as we saw in spring 2020 or several quarters as we saw with the Great Recession (September 2008-March 2009).

In my 25 year career, I have seen several correction and consolidation periods play out:

• March 2000 - October 2002 dot.com bubble bursts, rolls into the 9/11 attacks and choppy economic recovery.
• September 2008 - March 2009 financial crisis and Great Recession. We could even go back to December 2007 which was the S&P 500 peak, though many thought the December to August period was merely a consolidation at the time.
• June 2014 - February 2016 marked a consolidation period in the S&P 500 after the first waves of QE liquified markets.
• January 2018 - December 2018 the "sell vol" corrections that were likely spurred by QT (quantitative tightening) at the time and lead to a rare recent down year in stocks.

The current cycle began with overvaluation in January 2020 (which I talked about in 2020 Outlook: Euphoria To Despair and Coronavirus Is A Match That Lit The Overvaluation Tinder) and in my opinion would have led to a correction in 2020 regardless of the pandemic.

Covid though interfered with the natural progression and we saw the massive level of QE to combat the shutdown of the economy.

Fed Balance Sheet Trends

Federal Reserve

So, the question is, as QE ends, what should we expect?

The only real situation I see preventing an outright bear market is the Fed backing off of tightening. In that case, we'd see an extended choppy consolidation, in my opinion.

Investment Quick Thought

I am of the belief that the S&P 500 is going to see a lot of turnover the rest of this decade and cause returns to be choppy. I am calling this The Great Divergence. A period when the Zombie companies are killed out of the S&P 500 and replaced by companies that can grow their cash flows more consistently by taking part in the "4th Industrial Revolution" led emerging "sustainable smart everything world."

What I believe is developing right now is a potential long-term consolidation or outright bear market in large caps, as described above, marked by the Great Divergence.

In the face of those likelihoods, investors should be looking for less risk by selling the S&P 500 and at some point buying better ETFs and/or stocks than the S&P 500 which is populated by 150-200 zombies by my estimate.

At this point, based strictly on the overvaluation, I think SPY investors should consider this old stock market advice: in the face of a bear market, sell big, sell fast.

If you miss selling early, then simply rotate to better assets versus being out for a period. Time in the market tends to fix things, especially if you are able to upgrade your holdings.

Our proprietary technical and quantitative indicators suggest that we could see a small market rally in the face of tightening liquidity. (I will cover technical indicators after Friday's close, likely up on Sunday or Monday next week.)

If a short period of strength does occur, or if downward momentum accelerates, I would recommend getting to the level of cash I recommended for our investors back in October:

Short-term cash levels

Margin Of Safety Investing

While cash is not a great long-term holding, it is a legitimate short-term asset allocation position for managing risk and creating optionality for investing into a bear market or consolidation period.

Get your shopping list ready and be ready to scale in at key technical levels as downward momentum dissipates.

As far as where to look for some bargains now? Small caps are already beaten up and closing in on a bottom and have fared the worst the past year since peaking last February.

IWM vs QQQ vs SPY

TradingView

I am looking there first for bargains (more on that coming as well). As SPY and the Invesco QQQ (QQQ) corrections catch up to the iShares Russell 2000 ETF (IWM), will look within their holdings for stocks, as well as, likely buy QQQ at some point in place of SPY.

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.