The Market Is Overvalued, Over-believed & Over-margined – Plan Now For A MAJOR Correction

The stock market has had an outstanding five year run and, as such, I believe many individual investors have misguided expectations. With that said, however, the market is overvalued, over-believed and over-margined yet I am not arguing to get out but rather to be aware of where we are and to temper your expectations for the future. To help with that assessment a number of charts from various authorities are included showing different ways to look at valuations for today’s U.S. stock market and my estimates of forward-looking returns on total U.S equity portfolios.

So says Steve Blumenthal (cmgwealth.com) in edited excerpts from this article entitled On My Radar.

On My Radar this week I look at:

• Valuations
  1. The first chart shows median PE to be 21.5 (price times earnings) on April 30, 2015. The 51 year average median PE is 16.8.
     • the Median Fair Value (taking current earnings times 16.8) is a S&P 500 level of 1627.24. The market is at 2121 today and was at 2085.51 at April month end.
     • Overvalued is measured at a 1 standard deviation move above Fair Value or S&P 500 level 2128. We are a long way away from undervalued or S&P 500 level 1126.29.
  2. The next chart looks at S&P 500 PE based on (normalized earnings). The current reading is 20.3…
     • PE has been above 16.5 about 30.7 percent of the time since 1927 and over that time period the return averaged -0.5% when PE of 16.5 or higher.
     • We are in a high valuation = low return zone. Stocks are richly priced.
  3. This next chart is said to be Warren Buffett’s favorite valuation measure and shows the stock market capitalization as a percentage of gross domestic income. (Simply take the total number of shares outstanding times price and compare that to U.S. gross domestic income.)
     • You can see that we are at a higher level than we were at the market peak in 2007. Only March 2000 was higher. The charts shows the market to be in “bubble territory”.
  4. This dashboard is pretty cool. I see a lot of red.
• Forward Returns
  1. This next chart breaks median PE into five quintiles. The idea here is to divide all data points of PE since 1984 into quintiles and then see what the 10-year return was if your starting point was at any point in a given quintile.
     • Quintile 1 is best (lowest 20% of PEs) and Quintile 5 is the most expensive (highest 20% of PEs). If an investor bought in when the market was inexpensively priced in Quintile 1, the annual return over the subsequent 10-year period averaged 15.91%.
     • Conversely, if you bought in at any time median PE was in Quintile 5, the annual return over the subsequent 10-year period averaged 2.94% (note this is before inflation).
  2. The next chart looks at stocks as a percentage of total household equity ownership and tracks the subsequent 10-year return based on just how much equity individuals owned as a percentage of their total financial assets.
     • The idea here is that when investors have fully committed to the stock market, most of the money is in the game – having already bid up prices. When low, most of the money is out of the game creating buying power that ultimately comes back in to drive prices higher.
     • In short, the current data is telling us to expect returns over the next ten years of just 2.25%. Note the high correlation coefficient since 1952.
• Don’t Fight the Tape or the Fed
  1. In my view, so much hinges on the Fed and the overall market trend. I post this next chart from time to time in Trade Signals. It has been steadily deteriorating and while not yet at a -2 reading, it is just one step away. “It’s all ‘bout that Fed ‘bout that Fed”…
• Trade Signals
  1. I mentioned the following in Wednesday’s post
     • Cyclical Equity Market Trend: The Primary Trend Remains Bullish for Stocks
     • Volume Demand Continues to Better Volume Supply: Bullish for Stocks
     • The Zweig Bond Model: The Cyclical Trend for Bonds is Bearish Weekly Investor Sentiment Indicator:
       • NDR Crowd Sentiment Poll: Neutral Optimism (short-term Neutral for stocks)
       • Daily Trading Sentiment Composite: Neutral Signal (short-term Neutral for stocks though nearing Excessive Optimism which would turn the indicator Bearish)
     • Recession Watch – My Favorite Recession Forecasting Chart: Currently signaling No Recession
  2. Click here for the full piece including charts.

  Concluding Thoughts

• We are in an environment that favors a focus on absolute returns instead of relative returns. The problem is that the markets are doing their best to throw us a head fake and like 2000 and 2008, investors are biting on the move. Don’t bite on the head fake!The reality is that valuation metrics are very poor at predicting a market peak. Don’t Fight the Fed remains in place and there are better ways to more accurately risk manage the market turning points. I’m a big fan of NDR’s Big Mo (for momentum), yet nothing is perfect. Fortunately, there are ways to inexpensively hedge that doesn’t require perfect.
• What we can do is fairly accurately predict forward 5- and 10-year returns. Here too, not perfectly but we can get pretty darn close. With the market richly priced, forward returns just don’t look good enough. Worth the risk? I think it’s better to have a game plan in place that enables you to capitalize on the next major market correction – which in my opinion could be in the -40% to -60% range.
• Recessions tend to happen once or twice in a decade. The Fed and the global central banks are in play but the Fed is nearing a change in plan. Play defense until a better opportunity presents.
• There are a number of things that can drive the market higher than we might imagine: a rush of foreign capital into U.S. assets driven from negative interest rates and a loss of confidence in government and bank safety in Europe. I think it’s a probable maybe. How’s that for confidence? It could happen.

Stephen B. Blumenthal
Chairman & CEO
CMG Capital Management Group, Inc.