Word from Jeff- Dead Bull Walking? Or: The Boy Who Cried Bear

Not to pull a chicken little here, but it is no secret that I have been expecting a sharp pullback in US shares for some time. While there is, of course, no guarantee or fixed schedule for this, my thinking is in line with some pretty smart company, including the oft-referenced Robert Shiller, who has been warning about bubbly US stock valuations for some time.
The basic concept is this. Stocks represent ownership in companies. We buy companies to share in their profits. High profits and low stock prices mean a good deal, lower profits and high prices not so much. Both pieces are moving all the time, and investors can come to decouple the relationship, and consider stocks more like lottery tickets and less like the cash cows they are, or should be. The relationship between stock prices and profits is best known by the price to earnings (P/E or PE) ratio, but there are many (and better) ways to measure this that I won’t bore you with here. Low PEs – small price divided by big earnings – is good, high PEs – big prices, smaller relative profits – is not so good.
The US stock market is muddled by the fact that the economy is still in full recovery mode, and many companies’ earnings keep going up. That’s great, unless the stock price escalation gets ahead of the earnings escalation, as many smart people feel has happened in the US. The graph below helps to tell the story. When stock prices (purple line) go up faster than earnings go up (black dash), value measures like P/E get out of whack, and eventually come painfully down as the bubble pops, and a normal, appropriate relationship is restored. Take note: by various PE measures, prices have not been this lofty since 1929, or 1999, both market peaks before big drops. It does not help that borrowing money to invest in stocks – “margin” – is flashing warning signs as well, higher now than before the 2000 crash, and three times the level just before the 2008 meltdown. Make no mistake, US stocks are now one of the most expensive markets in history. Amazon – the “A” in “FANG” (the other tech darlings being, of course, Facebook, Netflix, and Google (now Alphabet)) – makes a great case in point. Yes, it is an incredible organization, and my go-to source for everything retail. Yes, it is an incredible disruptor, transforming and improving lifestyles in uncountable ways. But the Amazon phenomenon is premised on a rather incredible proposition: if the company breaks even (no profits!) it won’t pay tax, can pour cash flow tax-free into expansion, and can grow to control the world in record time (just kidding about that last, but not by much). Investors love it! No one seems to miss the “E” – the earnings. All expect that a textbook growth stock like this will one day spew enormous profits on the patient investors (or their grandchildren). But what if it never does? The stock value in many ways is un-tethered from the economic reality, but strangely, few investors seem to notice…
When a correction will happen I can’t tell you. Long term readers know I’ve been squawking about this for a long time, and still the bubble inflates. But it is making me very itchy, and I wanted to remind you that we are on alert, and you should not be surprised if we get a substantial drop. Also again, I am not calling a bear market, and don’t think you should get out of stocks. I do think that you should be well diversified across stock markets, and if you are concentrated in US large caps, you should take some risk off the table by spreading things around, particularly into non-US stocks which look a lot cheaper from a value perspective. Ditto for “value” stocks which, by definition, have somehow eluded the overvalued froth, and still represent solid deals.

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