Stocks: Should We Be Worried About Valuation Levels?
What Really Drives Markets?
Valuation levels are a constantly debated topic given their presumed influence on future investment returns. Yet, market forces regularly drive valuation metrics to extremes. We are at such a juncture, with cash flow as a percentage of market cap threatening to break below the historically low levels seen at the turn of the century. What are the possible implications?
A first conclusion that can be drawn from the chart is that a considerable amount of bullish investor sentiment is required to push valuation levels to historic extremes. Evidence of elevated investor optimism is supported by a sharp increase in margin debt over the past year, muted market volatility, low short-interest levels, and a host of other measures of sentiment that we track. It is axiomatic that extremes of market sentiment, both bullish and bearish, demand the attention of investors as they have historically preceded important changes in market trends. We view the very low current level of cash flow to market cap as symptomatic of investor optimism that is at concerning levels.
On a fundamental level, that corporate cash flow has not proven strong enough to sustain more attractive valuation metrics reflects the fragile nature of the economy, despite ongoing stimulus since the 2008 Financial Crisis. It is self-evident that cash flow is the lifeblood of any business. Current levels suggest, though their stocks may be currently performing well, that many companies may experience serious operating challenges when the next recession inevitably appears. These difficulties will exacerbate the next bear market.
So, does valuation matter? We say yes, from both the perspective of indicating a concerning level of bullish investor sentiment and in suggesting that many companies have a tenuous financial footing that may be revealed by the next recession.
We continue to expect the 2020s to be both economically and geopolitically volatile. Such an environment will punish the passive and complacent but will present great opportunities to prepared investors.
