Is There A Perfect Storm Brewing?
I have been warning for quite some time that the stock market, as measured by the S&P 500 index, is very overvalued. The index has been hitting new highs in the past few weeks and is now up almost 50% from its low in March. We have noted that part of that overvaluation may be due to the heavy weighting of just five stocks that make up a significant portion of the index (estimated to be in the 20% to 28% weighting range). Those five stocks are Apple, Amazon, Microsoft, Alphabet, and Facebook. But now the entire index appears to be overvalued as indicated by several measures.
To begin with, the median stock in the S&P 500 is now in the 100th percentile (the highest level possible) of historical valuation as measured by the forward price-to-earnings ratio, according to Goldman Sachs (Vigna, 2020). The S&P 500 index itself is in the 98th percentile of historical valuation.
Other measures support this overvaluation thesis as well. The price-to-earnings ratio (P/E ratio) of the S&P 500 at the close of the market on Friday was 29.20. Based on our research, a normal range for P/E ratios is in the 15 to 18 range. The Shiller P/E, or CAPE ratio, rose to 30.63 on August 11th, one of the highest levels in the past century.
Another interesting indicator is the “Buffett Indicator”, named for Berkshire Hathaway Chairman, Warren Buffett. According to Buffett, the market is overvalued when the market cap of public companies is higher than Gross Domestic Product (GDP). This indicator can be thought of as being something like a price-to-sales ratio (the market cap is the price for the companies in the economy and GDP represents sales). I will write more about the Buffett Indicator in a future Commentary. Currently, the market cap of public companies is $35.7 trillion, and GDP is $19.4 trillion. That puts the market cap at 1.84 times greater than the GDP, which is an historically high multiple.
Contrast this market overvaluation with the condition of the economy and the state of the world. We still have an untamed coronavirus. Unemployment is the highest it has been in a decade. Second quarter GDP was a negative 32.9%, and there is much debate over how quickly the economy can recover. The government is taking on massive amounts of debt to fund its stimulus efforts. Businesses and consumers are heavily in debt, and along with the government, were heavily in debt before the crisis hit. Corporate earnings for the S&P 500 companies are down to a level of $116 from $132.39 a year ago. Furthermore, we have a very divisive and hostile political situation with elections just around the corner, a source of much uncertainty.
Could we be in a speculative bubble? Consider Tesla at a P/E multiple of over 1,000. Granted Tesla is an interesting company that will undoubtedly play a significant role in the world for years to come. But at a P/E multiple of over 1,000, it is priced for more than perfection. I have students and others asking me about Tesla on a regular basis. Just today I had two different people tell me about Tesla: one said that they wanted to buy Tesla and one said they held Tesla and did not want to sell and take a profit. Tesla is not the only company that people are blindly bidding up to price levels not seen since the last speculative bubble. And when the average, novice investor starts jumping into the market and speculating on stocks like Tesla, it has often been a good time to recognize that there is a bubble about to burst. So, is the perfect storm brewing? You decide.
Reference
Vigna, P. (2020). Value of median S&P stock hits new heights. The Wall Street Journal. New York, Dow Jones & Company. CCLXXVI: B1. August 24, 2020.
Economic and Investment Highlights
Last Week
U.S. coronavirus deaths passed the 170,000 mark. Coronavirus cases in Europe are again surging.
Boeing is planning more job cuts.
Big retail chains such as Walmart and Target have been posting strong sales gains.
Apple became the first U.S publicly traded company to reach a $2 trillion valuation.
Airbnb filed for an initial public offering (IPO).
Fed meeting minutes from July showed the Fed expected that the economy would need more stimulus.
Jobless claims rose last week.
American announced it will suspend flights to 15 cities.
Home sales surged in July.
The U.S. economy showed some signs of recovery according to surveys of purchasing managers, though other signs indicate that the economy is still in a vulnerable state.
The S&P 500 and the Nasdaq rose for the week while the Dow fell for the week. The Dow was down 0.69%; the S&P 500 was up 0.72%; and the Nasdaq was up 2.7%. The 10-year treasury yield ended the week at 0.639%. Gold closed at $1,934.60 for the week. Oil closed at $42.34 for the week.
The Week Ahead
This link takes you to Econoday’s Economic Calendar and Economic Events and Analysis which shows the upcoming economic reporting events scheduled in the week and months ahead.
Summary
Note: The models below may not capture the impact of COVID-19 beyond their impact on GDP source data and relevant economic reports that have already been released. They may not anticipate the impact of COVID-19 on forthcoming economic reports beyond the standard internal dynamics of the models.
Note: The comments that follow are derived from the economic indicators referenced in the Resources section of this newsletter and other sources in this report.
The Aruoba-Diebold-Scotti Business Conditions Index (ALS) had been trending up for several weeks from having dipped in 2019. Recently with the advent of the economic collapse, the index crashed. It has now been generally trending up again, but fluctuating within a narrow band. This is a positive indicator for the economy on a short-term basis.
The GDPNow model estimate for real GDP growth (seasonally adjusted annual rate) in the third quarter of 2020 is 25.6 percent. This reading agrees with the ALS model assessment of an improving short-term economic environment.
The New York Fed Staff Nowcast stands at 14.6 percent for 2020:Q3.
The Chicago Fed National Activity Index (CFNAI) showed an increase in economic activity in June. The Chicago Fed National Activity Index (CFNAI) was +1.18 in July, down from +5.33 in June.
All told, these short-term economic indicators are a mixed analysis for the economy, at least on a short-term basis.
Expectations that stock prices will rise over the next six months is now at 30.4% in a recent AAII Sentiment Survey. The historical average is 38.0% for the survey. 27.2% of the investors in the survey described their short-term outlook as neutral and 42.4% were bearish. Please see the AAII Sentiment Survey for the complete results.
The latest Gross Output (GO) reading (July 6, 2020) showed that Gross Output slowed significantly in the first quarter of 2020.
On a longer-term basis, the forecasters in the Philadelphia Fed’s Survey of Professional Forecasters (as of August 14, 2020) predict real GDP will increase at 19.1 percent for the third quarter of 2020, 5.8 percent in the fourth quarter of 2020, 5.2 percent in the first quarter of 2021, 3.8 percent in the second quarter of 2021, and 3.6 percent in the third quarter of 2021. On an annual-average over annual-average basis, the forecasters predict real GDP to contract -5.2 percent in 2020; and grow 3.2 percent in 2021, 3.5 percent in 2022 and 2.2 percent in 2023. The forecasters predict the unemployment rate will be 10.0 percent in Q3 and 9.5 percent in Q4; and will be 9.0 percent in 2020; 8.0 percent in 2021, 6.0 percent in 2022, and 5.3 percent in 2023. The next survey release date is November 16, 2020.
The National Association for Business Economics (NABE) released an Outlook Flash Survey on April 10, 2020. The NABE panel expects GDP declines in Q1 2020 and Q2 2020, and upticks in Q3 2020 and Q4 2020. The panel believes the U.S. economy is already in a recession and predicts real GDP will grow at an annual rate of -2.4 percent for the first quarter of 2020, -26.5 percent for the second quarter of 2020, 2.0 percent in the third quarter of 2020, 5.8 percent in the fourth quarter of 2020, and 6.0 percent in the first quarter of 2021. The forecasters expect unemployment to average 3.8% in Q1 2020. The median unemployment rate projection for Q2 2020 is 12.0%. The unemployment rate is expected to fall back to 9.5% at the end of 2020, and to 6.0% at year-end 2021. The panel’s forecast for the PCE price index less food and energy calls for a slowdown in the annual rate of change from 1.7% in Q1 to 0.8% in Q2 2020. The panel expects the rate to increase gradually to 1.7% in the last half of 2021.
For a more in-depth review and analysis of the economy, please see our mini-book on economic analysis and forecasting entitled: Simple and Effective Economic Forecasting.
Stock Market Valuations
Our estimates of the market valuations for two stock market indices, the Dow Jones Industrial Average (DJIA) and the Standard & Poor’s 500 (S&P 500), can be found in the file below:
Conclusion
During this time of global flux due to the coronavirus, I am leaving the Conclusion discussion below the same as was posted on March 23, 2020. The March 23, 2020 discussion still adequately reflects my thinking on the current state of affairs.
Important Note: While I don’t believe it is time to jump back into the stock market in a big way because of the market’s overvaluation, I have been advising the last few of weeks in this Commentary and in my weekly podcast, Intrinsic Value Wealth Report Radio, that investors can continue building their investment portfolios by selecting individual securities that offer growth and value opportunities.
Reprinted from March 23, 2020
Up until the past week, the economy had been in a stable but somewhat vulnerable state. Nonetheless, it had remained fairly strong. In fact, robust consumer spending and strong labor market conditions had given us confidence that the economy, which had been in its tenth year of expansion, could continue to grow. But we were cautious on this outlook. There were several reasons for our caution. U.S. business growth had been mixed. And global economic growth had been mixed as well. The new coronavirus was becoming a global economic threat, although it was still too early to tell how much of an effect it would ultimately have. Debt is at high levels for consumers, businesses, and government (at all levels of government). Finally, this is an election year that will likely have significant consequences either positively or negatively depending on the outcome of the elections. And of course, it is still too early to tell what the outcome of the elections will be.
In just a few days, the coronavirus’s effect on the economy and the markets went from a ripple to a tsunami. Businesses are shuttering, events are being cancelled or postponed, grocery store shelves are empty, and people are being asked or ordered to stay home. The markets are now deep in bear market territory. The effects on the economy, even given the short time that the economy has been retreating, may be with us for a long time. There is now a much greater risk of a recession, and there has even been some talk of a depression. The government, the Fed, Republicans, and Democrats, and pretty much the entire country, is trying to get the virus under control and is coming up with plans to mitigate the long-term economic effects caused by the virus. But the virus has impacted the economy – in a significant way – in just a short time. How long lasting the effects will be no one can tell right now. The economy has been largely shut down and remains so today. It takes time to restart the economy after a situation such as what is occurring at the present time.
Given these events and the rapidly deteriorating situation, as I said last week, I would caution not to panic. The economy and the markets will get better. The situation is bad – there is no doubt about that – but it will turn around. The real question is when will it turn around? No one knows that at the present time. But it will turn around.
For now, review your investment portfolios. It is highly likely that all or most of your stocks are down. You should not consider selling the bulk of your stocks – only consider selling companies that are not sound companies. But do recognize that as the economy deteriorates, even good companies will be affected.
For stock market value hunters, we believe it is still too early to jump back in. We will be closely monitoring the markets using the many tools and models that we have developed over the years to assess the economy and the markets. We will use our best judgement and thoughts to let you know when we believe things are turning around. The turnaround hasn’t happened yet.
We believe it is important to maintain a long-term view toward investing. But for now, just sit tight. Eventually, this means that you should continue building your investment portfolio using the Cassandra Stock Selection Model to select individual securities that offer growth and value opportunities.
Chart for Review and Thought
Simple and Effective Economic Forecasting Model
Note: The table and chart below have not been updated. However, we believe that a recession is quite likely. In the chart below, the bottom green line shows what a recession could look like.
Notes (GDP Growth Chart):
- See the July 8, 2019 Commentary for an introduction to this model.
- Actual numbers 2007 through 2019; forecasted numbers thereafter.
- Normal GDP growth is typically in the 2% to 3% range.
- A recession is generally defined as two consecutive quarters of negative economic growth as measured by a country’s gross domestic product (GDP).
Thought for the Week
“The market does what it should do, but not always when.” – Jesse Livermore
Announcements
The Intrinsic Value Wealth Report has started a new YouTube channel called Intrinsic Value Wealth Report TV. You can view the YouTube channel at Intrinsic Value Wealth Report TV.
The Intrinsic Value Wealth Report has started a new podcast called Intrinsic Value Wealth Report Radio. You can listen to the podcast at Intrinsic Value Wealth Report Radio.
Dr. Wendee spoke at the Investment Club of America’s annual economic summit, called Econosummit, on Sunday March 1, 2020 in Las Vegas.
Dr. Wendee attended the The National Due Diligence Alliance (TNDDA) investment banking conference, which was held March 6-8, 2020 at the Four Seasons Resort in Dallas, Texas. This is a conference held several times throughout the year for investment bankers and registered investment advisers to learn about new opportunities in the Alternative Investment asset classes.
We have been researching the use of crowdsourcing for investment ideas. We will be sending a survey out in the next few weeks to get your input on the economy and the markets; and to get any investment ideas that you would like to share. We will compile this input and distribute the results to you and our other subscribers. We have been testing our crowdsourcing models with students and have been having good success and results.
Dr. Wendee has been researching and writing a new theory of economics known as, The Value Creation Theory of the Economy (also known as, Intrinsinomics). The full paper on Intrinsinomics will be published in the near future.
Finance 3350: Personal Finance-Portfolio & Risk Management– Dr. Wendee started teaching Finance 3350 – Portfolio & Risk Management at California State University, Los Angeles (CSULA) for the Summer term starting May 2020. Dr. Wendee teaches courses in Management and Finance at CSULA.
Business 548: Strategy and Decision Making – Dr. Wendee will be teaching Business 548 – Strategy and Decision Making at California Baptist University (CBU) starting at the end of June 2020. Dr. Wendee teaches courses in Finance, Business, Strategy & Decision Making, and Economics at CBU.
Business 303: Business Finance – Dr. Wendee will be teaching Business 303 – Business Finance at California Baptist University (CBU) starting at the end of August 2020. Dr. Wendee teaches courses in Finance, Business, Strategy & Decision Making, and Economics at CBU.
Dr. Wendee presented a paper on his new theory of economics known as, The Value Creation Theory of the Economy (also known as, Intrinsinomics), at the International Leadership Association’s annual global conference which was held in Ottawa, Canada last Fall.
Dr. Wendee will present an updated paper on his new theory of economics known as, The Value Creation Theory of the Economy (also known as, Intrinsinomics), at the International Leadership Association’s annual global conference which will be held in San Francisco, California in November.
Dr. Wendee is working on a financial planning modeling program which will be available in the near future. The modeling program is designed to assist anyone in creating a financial plan and is customizable for each person’s unique financial planning goals. A working draft of the model is currently in beta test with students. Click this link, schematic, to go to the clickable document under the subheading Financial Planning Process (Draft) in the Intrinsic Value Wealth Report to see a draft of the schematic for the new financial planning process.
Dr. Wendee has been developing an econometric model specifically designed to monitor and forecast the global economy as this current economic crisis unfolds. This new econometric model is based on other econometric models that he has designed and have used for many years. You can find some of these earlier models in Book # 6 – Simple and Effective Economic Forecasting in the sister website to this website which is called the Intrinsic Value Wealth Report. The new econometric model has been constructed with some additional tools and methods that he has learned and some that he has developed over the last several years. He will be talking more about this new econometric model in this Commentary over the next few months. His comments and forecasts on the economy and the markets going forward will be based to a significant extent on this new model.
We have begun raising capital for our fund-of-funds investment, Northwest Quadrant Opportunity Fund, LLC. The fund engineers and constructs an investment vehicle consisting of Alternative Asset investments. The fund’s objective is to build a diversified portfolio of strong, solid, steady- performing assets, with highly qualified asset managers who have proven track records that meet our underwriting requirements. To learn more about the Northwest Quadrant Opportunity Fund, LLC and to obtain an offering memorandum, please click Northwest Quadrant Opportunity Fund, LLC.
Intrinsic Value Wealth Creation pyramid
We always conclude our commentary with a discussion of the Intrinsic Value Wealth Creation Pyramid. The Intrinsic Value Wealth Creation Pyramid is designed to show some of the major categories for building wealth. It is the result of many years of study of the wealth building process; experience working with clients who have built considerable wealth; and my own personal experience building wealth. Newsletter subscribers should consult the Intrinsic Value Wealth Creation Pyramid as one of many useful investment tools while considering their investment plans.
The chart in this section is an expanded version of the Intrinsic Value Wealth Creation Pyramid Chart referenced in the Forbes.com article entitled, Nine Of The Best Ways To Build Wealth.
RESOURCES
See our Resources section for links to economic and other resources used in the preparation of this Commentary.