Either the stock market’s action has become irrational or the financial press has made an error with describing the market’s action on Thursday. The headline is that a two-week-old video where James Comey said Trump didn’t obstruct the FBI’s investigations caused the rally. I’m not making a comment on the political implications of this, but it would be bizarre for the market to react to old news. This plays into my theory that the market sold off because the action had been too quiet and the economic data has weakened. That theory says that stocks are rallying Thursday because the selloff was too sharp.
Whether the rally was a minor reversal of the prior day’s selloff because it went too far or caused by political rumors, it doesn’t change the fact that the S&P 500 rebounded 0.37% and the VIX fell 5.97%. The one day selloff can be construed as a positive by the bulls because now the ominous lack of volatility phase has ended. As long as the GOP’s economic agenda is unencumbered, the rally can continue.
As a reminder, saying that the rally can continue is not me buying into the bullish thesis. It’s merely my acknowledgement that the latest bullish narrative hasn’t been tarnished. Bullish investors are basing their thesis on the fact that earnings were strong in Q1 and that GDP will rebound in Q2. Given the positive industrial production report form April and the low bar Q2 GDP must jump over, this thesis looks to be unaffected by the political drama.
As I mentioned in a previous post, the long Nasdaq trade is considered to be the most crowded by fund managers. The chart below is consistent with the survey about the Nasdaq. As you can see, the net percentage of fund managers who think the equity market is overvalued has reached the level not seen since the early 2000s during the height of the tech bubble. This chart makes sense because the Shiller PE is at the highest level since the dot com bubble. It is surprising though because you would think if enough fund managers thought stocks were overvalued, they would sell them, causing a correction.
From my discussions with investors, I can say that many are aware that stocks are expensive, yet they are long the market. This illogical decision making is caused by the fact that investors have decided to go with what is working rather that worry about being right. It’s consistent with the classic trading phrase ‘don’t be a hero.’ Investors who are long the market don’t want to fight the trend. That philosophy works until the peak. The chart above shows be how many ‘weak hands’ are in the market. If enough investors realize the market is expensive and are only following the trend, they will be shaken out at the first sign of trouble. This can turn a small selloff into a major crash. I don’t see how the political noise of the day could catalyze such action.
It’s objectively true that stocks are expensive. I’ll now review some different spins on valuation opposed to the usual PE multiple and sales to GDP ratio line charts which are common. The chart below shows the price to forward operating earnings multiple if a consistent margin of 8.2% is used. The margin of 8.2% was used because it is the historic average and is also the average of the past 10 years. Margins are high because employee pay is low and corporate taxes paid is also low. Because margins are higher than 8.2% now, the current relative valuation is more expensive in this chart compared to a regular chart showing PE multiples. As you can see, the market is slightly cheaper than the peak in the early 2000s.
The chart below shows the relationship between the returns the margin debt to GDP ratio is forecasting for stocks and the subsequent 3-year returns in stocks. The correlation between the forecast and actual results was tight from the mid-1990s until 2010. In the past few years, the margin debt to GDP has risen to levels associated with a speculative bubble. However, instead of stocks coming back down to Earth, they continued their march higher. The current forecast for returns is worse than the peak of the previous two bubbles, yet stocks ignore this red flag.
The chart below plots a dot for where the market’s market cap to GDP ratio is every year and shows the subsequent 3 year returns. When the market cap to GDP ratio is high, typically returns are negative. The chart shows that this cycle has been the first time ever where stocks have gotten expensive, yet still had good returns. Timing when valuations will start to matter again is impossible. The question you must answer as an investor is whether you think valuations will ever matter again. If you think they won’t matter again, then buying stocks is logical; if you think they will matter, caution makes sense.
Investors aren’t the only ones shelling out more money for firms. The chart below shows the median prices paid in M&A activity. As you can see, debt to EBITDA and equity to EBITDA multiples have reached the highest rate since the financial crisis. If firms are being valued based off the fact that peak margins will continue, the buyers will be regretting their purchases in a few years. The best thing firms can do is to sit on their excess cash and wait for a downturn to get better prices on deals. For management teams who only plan to stay with the company for a few years, the cash burns a hole in their pockets causing them to spend money on pricey acquisitions.
Conclusion
It’s tough to say if stocks rallied because of a two-week-old video or not. What isn’t tough to say is that stocks are expensive. Surprisingly most fund managers agree with my analysis. You would think that would cause stocks to fall, but so far it hasn’t. Earnings and margins will have to decline for me to press my bearishness. For now, the rally will continue unabated by this temporary political noise.
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