Is The U.S. Stock Market Overvalued Right Now?
By Eric Nguyen, CFA on The Capital
June 10, 2020 — In this article, I will share my opinions on whether the U.S. stock market is currently overvalued, and what can be the potential catalysts for a market correction.
Is the U.S. stock market currently overvalued? The short answer is YES. Here is why.
1. Market capitalization to GDP ratio: We are approaching an all-time high market value in comparison to GDP, despite fundamental economic weakness.
The Wilshire 500 / GDP ratio is a long-term valuation indicator for the U.S. stock market. Any reading above 1.0x indicates an overvalued market. This indicator has been made popular in recent years by Warren Buffett. As we can see, the ratio is creeping back up to 1.49x this month, which is only 6.6% lower than the historical high reached back in January prior to the global spread of the pandemic.
What is notable about this ratio is that while it is reported on a monthly basis as is the basis of the index nominator, the denominator is the sum of the four most recently quarterly GDP numbers, as reported by the St. Louis FED. The latest GDP figure reported is Q1 2020. This means that once the (expectedly suppressing) Q2 2020 number has been reported, this ratio might surpass the all-time high in January, and this has not even taken into account any stock market rises until then.
The rise of this very ratio is itself a potential catalyst for stock market reversal, as institutional investors might soon become unease given the increasing disparity between the current stock market valuation and the economic reality. They may not do so following the report of the Q2 2020 number because it has largely been baked into Wall Street’s expectations. Having said that, any possibilities of continued economic weakness extending into Q3 2020 and thereafter (which is starting to look more likely given the rising number of new infection cases following the ongoing protest) might likely trigger a sell-off.
The S&P 500 P/E Ratio, which is widely used by investors, also points to the same conclusion. Since the Great Depression with the exception of the Dot-com bust and the Great Recession where the market hit extremely high P/E ratios, the stock market reached the P/E range of 20–25x six times, and every time it was followed by a correction. On those six occasions, the bull market between 2015 and 2017 was the most enduring. The market persisted within the “stocks are in a bubble” 20–25x P/E range for 3 years from January 2015 to December 2017 before a subsequent correction took place, which is in stark contrast to the other five times where the correction occurred within only 1.5 years of the market embarking on this territory. As the latest bull market started in January 2018, this means that if the ongoing stock market run-up continues, we might see a correction sooner than we think.
Don’t just take that from me. In the speech of Fed Chair Jerome Powell on June 10, when asked by a CNBC report whether he saw the possibility of a market bubble that may pop and set back the recovery, he responded: “Just the concept that we would hold back because we think asset prices are too high, whether others may not think so, but we’ve just decided that it’s the case, what would happen to those people (the people that we were supposed to be serving)?”. Despite the Fed’s current commitment to keeping the interest rate low until 2022 to boost consumer confidence, when the head of the institution that runs the economy thinks asset prices are overvalued, you know what will happen the moment there are signs of economic recovery.
At this stage, any signs of a sustained economic recovery may very well be the catalyst for emerging expectations of a Fed rate hike and a market correction.
2. Continued economic weakness and structural economic shifts: There is an increasing probability of economic weakness extending into Q3 2020 and tectonic shifts in corporate and consumer spending patterns.
Let’s look at the underlying economy. The largest component of GDP is consumer spending, and there are 3 main drivers of spending being (1) employment and wages, (2) prices and interest rates, and (3) consumer confidence.
Employment and wage weaknesses are not expected to go away any time soon. The monthly unemployment rates, without the survey misclassification, are at 16.3% in May and 19.7% in April, or among the highest since the Great Depression. Wages declined by 8.0% in April, with May figure yet to be released. With mounting job losses and uncertain prospects of re-hiring, it is no wonder consumer confidence is only slightly higher than that during the Great Recession despite near-zero inflation.
The other components of GDP, i.e. investments, government spending, and net exports, are not too great either. With corporate debt level at an all-time high, timid consumer demand, and significant economic uncertainties, corporations are cutting back on capital investment significantly, as indicated in a survey from PwC. Government budget deficit, despite widening by US$1.88 trillion during the first 8 months of this budget year — larger than even any annual shortfalls in U.S. history, has not been effective in stimulating consumer demand. People are saving, as opposed to spending, and putting their stimulus checks into cash buffers, and one of those places is the stock market. The PPP stimulus program, which was supposed to help small- and medium-sized businesses, was not particularly well-designed either, as capital loans are made through banks and businesses with better relationships (typically the richest businesses) with the banks got ahead of the line.
The U.S.-China tensions intensified during this pandemic and could become a bigger headwind for the U.S. economy and the stock market. The U.S. crackdown on Huawei, U.S.’s conflict with China over the new security measures for Hong Kong, a new bill passed by the Senate in April on increasing oversight of Chinese companies listed in the U.S., and the upcoming presidential election with Trump escalating disputes with Beijing on both political and economic fronts are among (but by no means, all of) the contributing factors. As a result, there is reason to believe that even the Phase 1 trade deal with China will not be honored, and any possibility of a Phase 2 deal completely out of the question. With China being the U.S.’s largest trading partner, these intensified tensions will hold us back on the path to post-pandemic recovery.
3. The peak of irrationality: Money influx into low-quality stocks of bankrupt companies.
When high-quality stocks of cash-rich and well-managed companies (think AAPL, GOOGL, etc.) have been bid up too far too fast, speculators started to look for new places to park their cash. In this current environment, even risky stocks of companies most stricken by the COVID-19 pandemic and mired in debts (think AAL, UAL, etc.) have seen a rapid rebound in recent weeks.
What is even more alarming is that there has now been an influx of money into low-quality stocks of bankrupt and ill-managed companies. Take Hertz (HRTZ), Whiting Petroleum (WLL), and J.C. Penney (PCPNQ) for example. These companies have all declared bankruptcies in the past two months, yet their stocks have seen their best one-week performance ever of 390% (HRTZ), 180% (WLL), and 105% (PCPNQ), respectively. If there were any promising prospects of a turnaround for these companies to be bet on, that would be a completely different story. Not in this case though. As inexperienced investors started to pile in, they might soon realize that these are nothing more than hot potatoes and they might get burnt (and stuck) holding them.
This market development should give the rest of us something to worry about. The extreme swing of the market psychology pendulum, in this case towards euphoria, has always been itself responsible for the swing towards the opposite direction of the pendulum.
Disclaimer: All opinions expressed by Eric Nguyen on this website are solely Nguyen’s opinions as of the date indicated and do not reflect the opinions of any companies or affiliates that Nguyen is or is not associated with. Such opinions are subject to changes without notice. You should not treat any opinion expressed by Nguyen as a specific inducement to make a particular investment or follow a particular strategy, but only as a mere expression of his opinion. Nguyen’s opinions are based upon information he considers reliable, but neither Nguyen nor any companies or affiliates that he is associated with warrants its completeness or accuracy, and it should not be relied upon as such.
