The Great Disconnect continues, thanks to the US Federal Reserve and their global central bank cohorts. Covid-19 has proven to be a tenacious adversary, creating financial and social upheaval across the world. The job market continues to be stuck, with weekly new unemployment claims registering about one million new claims per week, and “continuing claims” for both state and federal unemployment relief being received by 27 million people. Layoff announcements are dominating the headlines as companies warn that when pandemic relief programs expire (many at September’s end) they will be forced to permanently lay off employees that they’ve kept on the books in anticipation of a turnaround that remains elusive. Wall Street, meanwhile, has rocketed to new highs (for the S&P 500 and NASDAQ anyway) and is enjoying one of the strongest summers in its history. For Wall Street, these seem to be the best of times.
Short-term rescue interventions by governments or central banks during a sudden crisis, such as the pandemic, are one thing, particularly if they support the unemployed, but also if they unfreeze credit that had frozen up even for healthy companies. But since 2008, these short-term rescues have become long-term policy, with financial markets now being completely dependent on central bank largesse. Each new wobble in the markets is being met with additional rounds of liquidity by our friends at the Fed, which has now expanded its balance sheet to just over seven trillion dollars. With companies downsizing and so much money sloshing around the system, it’s no wonder stocks are rising—there’s simply too much money chasing too few investments. Central banks behave as if they have outlawed bear markets, but in doing so, have become serial blowers of financial market bubbles.
Unfortunately, the Fed’s approach has done away with the quaint notion of stock prices being determined by logical factors such as revenues, earnings, cash flow, or interest rates. It is all about the never-ending flow of liquidity that’s keeping markets up now. But can that effect continue forever?
We don’t think so. Everyone on Wall Street knows the old saying “trees don’t grow to the sky.” We believe the stage is now set for some pruning to take place in stock prices.
While much has changed in the covid era, one constant that can be relied on is human behavior. Advisor’s bullish sentiment, as measured by Investor’s Intelligence, has now reached the danger level of 60%, while bears drift at 16%, equal to 20-year lows. In recent years, this indicator has had a good record of timely warnings of impending corrections. Today’s red-hot bullishness equals that seen at the highs of 2008, early 2018, and December 2019, areas from which significant declines occurred.
Bullishness this high indicates that anyone who wants to be invested has gotten invested, and that investors have little cash left to fuel the market higher. In the world of the bubble blowing Fed, cash availability may no longer be a constraint, but many other examples of overly risky behavior are on full display at Wall Street’s covid party, supporting the message from advisory sentiment.
The rise of day trading is one example. Computer savvy workers, perhaps bored at home or needing to make extra money, have combined with trading apps such as Robinhood and zero trading commissions to cause day trading to be vogue again, ala 1999. This has been reinforced by the spectacular rise in consumer technology stocks such as Apple, Amazon, Google and Tesla. These top stocks have proven to be a magnet for individual and institutional money alike, and have driven their influence on the market indexes to bloated levels.
Apple alone now counts for 14% of the NASDAQ 100, while the top three stocks in that index account for 35% of the weight. Those same three (Apple, Microsoft, and Amazon) have 18% of the weight of the S&P 500. They are clear beneficiaries of the work-from-home reality, so they and their technology brethren have garnered the most investor attention and dollars. In a world where business has suddenly downshifted, they offer the only game in town for growth-seeking investors.
This is reminiscent of the Nifty-Fifty era of the late 1960s. The “fifty” referred to the top fifty growth stocks of the time, which rose to astounding prices and valuations, and dominated the markets of the day. The drop from their lofty zenith of 1972 has become historians’ classic example of the risk of bullish sentiment overwhelming stock fundamentals. Concentration in just a few, “can’t lose” stocks is another sign of investor complacency about a seemingly unstoppable uptrend.
The advance/decline (a/d) line also offers a warning of possible change of direction. The a/d line will normally show more stocks going up in price on days when the indexes rise. In recent weeks, however, there have been numerous days when the a/d line has been negative, even though the S&P 500 or NASDAQ reached new highs. This is a troubling sign that most stocks are under selling pressure even as the index heavyweights described above rise. In Wall Street’s parlance, the generals are leading, but the soldiers (the lesser stocks) fail to follow. This divergence indicates that the rally is on increasingly shaky foundations, as the weight of selling can eventually overwhelm the influence of even today’s popular tech favorites.
A similar divergence is occurring with the CBOE Volatility Index, known as VIX. Affectionately called the “Fear Gauge” the VIX measures the market's expectation of 30-day forward-looking volatility (i.e. price changes). Simply put, if the VIX is falling, low volatility is expected, and higher volatility is expected when it is rising. Typically, market indexes and the VIX move in opposite directions. But lately, in a similar vein to the developing a/d divergence, we are starting to witness numerous days when the VIX is rising on days when the indexes are rising, the opposite of normal behavior. Divergences from the norm, especially at index extremes, can signal a reversal of the prevailing trend. From a longer-term perspective, the VIX has now given a buy signal on its point-and-figure chart, indicating that VIX values, and volatility, are headed higher.
Finally, investors must consider the elephant in the room, which are stratospheric stock market valuations. Thanks to the bubble-blowing efforts of the Fed to keep asset prices up no matter what the economy is doing, valuations in the stock market continue to defy logic and rational analysis. There is nothing new in this, as the Fed’s money printing policy has artificially inflated valuations for the last 11 years, and shows no sign of stopping.
Evidence of bubble-like valuations should be the primary concern for long-term investors. Valuations, unfortunately, are in the eye of the beholder, and there is no standard measure for what “expensive” and “cheap” really are. An illuminating view of valuation, that avoids forecasting errors and dependence on earnings estimates, is one that compares the value of corporate equities to Gross Domestic Product.
Market Cap to GDP is a long-term valuation indicator that has become popular in recent years, thanks to Warren Buffett. Back in 2001, he remarked in a Fortune Magazine interview that "it is probably the best single measure of where valuations stand at any given moment." It avoids earnings forecasts by simply comparing two values, total value of the stock market to US gross domestic product. Though data only go back to 1951, it makes glaringly clear that we are back to the valuation peaks that marked the internet bubble top in 2000.
Why should this matter to investors? History has shown that one of the few reliable guides to future returns are the valuations at the time of investment. With virtually every accepted measure of stock market valuation continuing to hover at overvalued extremes, is today’s investor complacency justified? We think not.
Bullish sentiment clearly shows the rally has reached the euphoria stage, and the deterioration of the a/d line and rise in VIX indicates the smart money is taking profits. In today’s bubble world, garden variety corrections can quickly snowball into major price declines as day traders panic and computer sell programs kick in. Prudent investors would be wise to tread carefully and let the stock market bubble follow its predictable path to deflation.