This is the second in a series of articles which addresses the disparity between rampant stock markets supported by artificially suppressed and unnaturally low interest rates, unlimited debt creation (money printing) by central banks and driven by overly complacent and extremely optimistic investors and an extremely fragile global economy.
There is a growing public perception that the pandemic is now over with the development of effective vaccines. Whilst it is a positive development, it will take time for the vaccine to be rolled out. In the meantime, the new strain of the virus which we are being told is more infectious, is forcing Governments to reintroduce full lockdowns for an indeterminate period of time to enable health care systems to cope with record levels of hospitalisations.
Many questions remain unanswered. We don’t know how long it will take for the vaccine to be rolled out on a global basis. We don’t know how long antibodies last for. We don’t even know how long the vaccines will work for.
According to the World Health Organization’s Top Emergency Expert, Mike Ryan, data is starting to emerge that reinfections may occur; conceding that vaccines on their own might not be enough to end the pandemic.
We do not expect the path to economic recovery in 2021 to be smooth. Lockdowns will cause economic scarring in some sectors of the economy, which, when combined with high levels of government, corporate and private indebtedness will act as a huge drag on future growth prospects.
This doesn’t mean that the ‘asset bubble’ (extreme stock market valuations) is about to hit a wall. The truth is, irrational as it may seem, the stock market may well trend higher for a while longer. This rally is nevertheless unsustainable and will meet a dramatic end. How soon is anyone’s guess.
What we can safely say is that stock markets are grossly overvalued when judged against any historical measurement standard – at levels rarely seen in over 100 years.
The US S&P500 Index is currently trading at 33X earnings which is its second most expensive price point since 1880 – only surpassed during the dot-com debacle – and we know how that ended up.
The cyclically adjusted price earnings ratio (commonly referred to as the Shiller Ratio) which provides an inflation adjusted reading of earnings per share over a trailing 10-year period produces a fairly similar reading.
In fact, all major valuation models arrive at the same conclusion. The table shows that Price to Sales (2.8X), Price to Book Value (3.9X), Enterprise Value to EBITDA (15X) and Enterprise Value to Sales (4X) multiples etc are at all-time highs.
Less familiar valuation methods (similar to Warren Buffet’s Market Cap/GDP Ratio) also show that the 25 largest growth firms are overpriced relative to US GDP by a record breaking 62%.
The risk appetite graph shows investors have become overly confident about future market direction. There is nothing we have learned during the reporting season to justify these extremely rich valuations nor euphoric investor positioning at levels last seen prior to the dot-com and global financial crisis market crashes of 2000 and 2008.
The Panic/Euphoria Model
This view is supported by another key sentiment indicator – the weekly CBOE ratio of volume traded in Puts versus Call options which fell to its lowest level in 20 years. This suggests that investor positioning is extremely skewed to the upside through the use of leveraged derivative instruments – ignoring the ongoing market risks.
The Institute of International Finance has warned that the pace of debt accumulation will leave the global economy struggling to reduce borrowing in the future without significant adverse implications for economic activity.
We know the market is in trouble when the number of US companies filing for bankruptcy (notwithstanding the huge financial support extended by the US Government) is fast approaching Global Financial Crisis levels.
About 25% of Russell 3000 will struggle to service their debts should interest rates costs edge higher.
Zombie firms are sitting on $2 trillion of debt which may never be repaid.
These same sentiments have been echoed by Berkshire Hathaway’s Vice Chairman, Charlie Munger, who has also questioned how central banks can keep supporting stocks? He is quoted as saying that ‘we are very near the edge of playing with fire.’
You know the market has lost all sense of perspective when Tesla (even after making allowances for the fact they are driving the Electrical Vehicle revolution) is trading at 1500X earnings with a greater market capitalization than the combined market value of the Top 10 automakers. These are all highly profitable companies with a strong market position driving combined revenues of $1.3 trillion compared to Tesla’s $28 billion.
You start wondering whether the market is rigged when the 10 Year Government Bond Yield of countries close to defaulting during the GFC – Portugal, Ireland, Italy, Greece & Spain – is lower (therefore perceived to be lower risk) than the equivalent 10 Year US Treasury Note.
CONCLUSION
We are in dot-com bubble territory and it may well end the same way with 50% wiped off stock market valuations.
All it takes is for the bigger players to exit a frothy market and take short positions for the markets to experience a sharp reversal in fortunes.
The most important thing to remember is that we are dealing with probabilities rather than certainties so anything and everything can change in the blink of an eye.
NEXT ARTICLE
Our next article scans the investment landscape for opportunities in hard assets which provide protection against future market volatility and a painful near-term correction; as well as ‘longer term’ opportunities in hypergrowth tech driven sectors.
