Reality Check: The Market Is Closer to a Top Than to a Bottom
Over the past several weeks, investors have become optimistic once again. The stock market has begun to climb, and the economic data seem to be coming in stronger. We are once again starting to see outperformance come from the higher beta stocks, such as small caps, growth stocks, and consumer discretionary stocks. Meanwhile, utilities and consumer staples are beginning to underperform, and Treasury bonds — the go-to safe haven asset for many investors — have broken their uptrend.
In addition to this new leadership, we are seeing the volatility index continue to weaken, which means that stock market insurance (e.g., put options) are extremely inexpensive. This gives investors a compelling reason to get long and stay long of stocks. Investors can simply buy stocks that they feel are overextended or overvalued, but which are still cheaper than bonds, and then buy cheap put options. If the market falls they are largely protected, and if it rises they get the upside appreciation.
There is simply no way to lose in the stock market, and this is what has everybody so bullish. But this is what is so worrying. A bull market needs to climb a wall of worry. That is, it needs for there to be bears out there so that there are people who change their minds, jump in, and push prices higher. But with the market at record highs and with insurance so inexpensive, there are seemingly no more bears.
Nevertheless, there are reasons to be bearish aside from simple contrarianism, although this is a good reason to consider the bear case.
First, stocks are historically extremely overvalued. Dividend yields are about a third of what they should be in an environment where stocks are attractive, and price-to-earnings multiples are about twice what they should be. Now, bulls will respond that this is the case because interest rates are so low and that the overvaluation in stocks merely reflects the fact that they are preferable from a relative standpoint. Furthermore, bulls might respond that while price-to-earnings multiples may look high, they aren’t given the future growth in earnings.
In response to the first point, investors who believe it fail to realize that we don’t live in an “either stock or bond” world. Investing paradigms often isolate these two assets as our only options, and we often see portfolio strategists tell us what ratio of stocks to bonds we should hold, with the sum comprising 100 percent of an ideal model portfolio. This is nonsense, and there are plenty of other assets out there including cash, foreign currencies, gold and other commodities. Over the past 15 years or so, the last group — gold and commodities — has significantly outperformed stocks and bonds.
In response to the second point, the anticipated growth is just that: an anticipation. Nobody has a crystal ball, and our growth expectations — in fact, our market expectations more generally – are formulated by our experience of the recent past. We have seen profit growth, margin expansion, and successful share buybacks, and so we expect to see this continue. When the market was collapsing in 2009, people expected further deterioration, a depression, and no profit growth. Few people were calling for record highs in the stock market five years later.
Does this mean that you should sell everything now and go short? Probably not, but you need to ask yourself how much more the market can run, how much higher can valuations get, and what is going to drive the market higher. Historically valuations have been higher, and there have been times in history when selling in similar market environments has been premature. But the fact is that we really don’t know, and we have to make our decisions based on probabilities.
The probability of the market rising sufficiently to make stock ownership worthwhile in the coming months and years is not zero, but historically it is small. Most of the times we’ve seen valuations and scenarios similar to what we are seeing today, we have been on the cusp of a rather severe bear market.