With stocks clearly defying Covid-era economic reality, investors may rightly ask themselves if they have found themselves in bubble-land yet again.
Already gut-punched by Covid-19, investing in stocks has seemed to become riskier and riskier as coronavirus cases mount.
I don’t care if you’re in index funds, the S&P 500, or even a single individual stock, you can’t help but have noticed that stock prices seem to have become unhinged from the black pit the global economy has been dancing on the edge of.
Some may ask themselves why the S&P 500 is not a good predictor of the U.S. economy. This is a valid and very important question. The implication is that stocks are high – at or near records on the Dow Jones Industrial Average, the NASDAQ, and the S&P 500 – because economic good times are on the verge of coming roaring back.
Are they? That is very doubtful.
The stock market is a leading indicator, it is true. It tends to go down before the economy gets slammed, and go up before the unemployment rate and other economic measures show improvement.
But Mr. Market is also a very fickle customer. There’s an old saying on Wall Street, that “the market can stay irrational longer than you can stay solvent.” This usually is applied to short sellers, who bet that a market with no logical reason to be high must come down. Often, they get outvoted by irrational investors paying crazy prices for overvalued stocks.
Investment in the stock market always carries some risk. Stock trading is not a perfect game. Mutual funds can gyrate wildly. Knowing when to buy and sell in the financial markets is in the best of times mysterious.
Right now, things may be good on the New York Stock Exchange, but are they good in the real world where people make and spend money and fuel the profits of the companies in the S&P 500? No!
Is your chief investment in your stock portfolio? Are you running it like a professional chief investment officer?
There are two massive and opposing forces acting to shape investors’ views on stock prices now.
The first is the unprecedented, devastating chill Covid has placed on global commerce. For most companies – I mean the overwhelming majority, ‘round the world – the lifeblood of sales revenues are way, way down. Bankruptcies are hitting the wall left and right. Businesses small and large are barely clinging to life. The economic fuel of consumer spending is decimated by layoffs and fears of layoffs. And, regardless of what the politicians or wishful thinking may say, we are really just in round one. The worst impact – on health and on economics – is yet to come, and probably not due until 2021 or later.
This is a chilling thought but an inescapable conclusion.
It’s bad. It’s gonna get real bad.
So why is the market partying like it’s 1999? (whoops!)
Well, the Fed has never ridden to the rescue quite like this before. Not during the Great Depression, or even during the 2008 Great Recession, has the Federal Reserve been so loose with printing-press cash, or so eager to intervene in the markets by buying to prop up demand and prices. Pretty much ditto for central banks around the world.
This is Kool-aid of a very high order. It is literally juicing an economy on intensive care life support. And it is serving up a crack-pipe high to too many stock investors, all out of proportion to the life-support med drip to an economy at death’s door.
Why do I say that? Ain’t low rates and lots of easy, easy money good for business, and good for stocks?
Of course it is. You can bet your bottom bippy on that.
But when it comes to stock investors’ expectations, what looks like all the money in the world may really be like trying to fill a mine shaft with a teaspoon. And even the open-checkbook Fed is making future-is-murky-and-dangerous noises, which is of course the reason for the open checkbook.
Let’s do some fact checking. Stocks are now trading near their peaks back in 2019. Two things about 2019.
1) The worldwide economy was singing. Companies were making money hand over fist. Things are a little different now, but you couldn’t tell that from stock market prices.
2) Even last year, when the good times were undeniably rolling, pundits the likes of Nobel Laureate Robert Shiller were warning stock prices were in a bubble and bound to come tumbling down.
Again, things are now a little different. Companies’ financial statements are crushed and unpredictable. The future is so uncertain that many are not even issuing guidance of expected revenues and earnings.
So how to value stocks? It has been said that in the long term, the market is like a weighing machine, but in the short term it’s like a voting machine.
In more sober times, one looks at the future earnings capacity of a company, and ties that back to a fair value. Kinda like pricing a house based on how much rent you can clear. This is called fundamental analysis. It’s the weighing machine part.
Right now, there is no way to weigh. For most companies, future revenues are just unknowable. Estimating profits and assigning prices is just shooting in the dark.
So that leaves the voting machine. The popularity contest. This method – prone to wishful thinking and always trumped by the weighing machine in the end – tends to produce some wacky results, both on the under-value and over-value side.
Right now, things look to be wildly overvalued. If Shiller was warning bubble last year while the economy was rocking, what does that say about now?
Are we in a stock bubble?
I’ve dredged up a few quotes from a PhD class study I did on stock bubbles a few years back.
See how these move you in the context of today’s world.
The Financial Times defined a bubble as “when the prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely – at which point the bubble ‘bursts.’”
Shiller said “I define a bubble as a social epidemic that involves extravagant expectations for the future…social mental illness – excessive self-perpetuating feedback fed by greed, envy, enthusiasm, media amplification, regret on missing out and fear of not catching up…”
Ron Insana noted that “bubbles are a recurring phenomenon – people persist in chasing prices divorced from underlying economic reality and seem not to learn from the past or apply rational pricing rules during euphoric periods. Bubbles form when the price of the asset becomes divorced from the underlying economic realities of reasonably anticipated profits…any significant increase in the price of an asset…that cannot be explained by the ‘fundamentals.’ Bubbles amount to massive delusion: too often, people fail to remember that trends don’t go on forever, and don’t learn from past.”
So are we in a bubble? It sure looks like we may be. Stock prices seem utterly disconnected from reasonably predictable earnings for a year or more. For this reason, we continue to counsel caution. Keep lots of dry powder. Odds are strong prices will drop and much better buying opportunities will present down the road. Hedge your bets. Keep some stock exposure, but emphasize companies with clear guidance and sectors that seem favorable in today’s challenging economic times.