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All Time High Valuations

The entire U.S. population seems to be caught up in watching the stock market lately. It is pretty incredible how our economy can be in such rough shape from the COVID-19 pandemic and yet our stock market can be achieving all time highs. 

There are several reasons behind this, the biggest of which is the Federal Reserve. The Fed keeps proving time and time again that it will not let the stock market drop materially. Every time it has over the last 10 years, it comes to the rescue injecting fresh liquidity to prop it up.

The second reason is from all the new federal spending to combat the crisis. Given how our system is plumbed, a majority of this money will find its way to corporations directly or indirectly, and so stock prices reflect this likelihood even though it will take some time to materialize.

The last reason is we are in a bit of a stock market mania (dare I say bubble?). Every so often, investors (especially those new to investing) get over confident in their beliefs and think there is endless upside. This allows stock prices to decouple from their long term valuation trends and reach new extreme levels.

Take Apple for example. You would think that a stock that goes from $100 per share in July 2016 to nearly $500 today is doing that because the business is 5 times bigger. Well, you'd be wrong. In 2016, the company earned Net Income of $46 billion and today earns income of $58 billion which is only 26% better, not 400% better. And this Net Income is flat since 2018 meaning it hasn't grown the last two years.

So what is going on? Well, this is the very definition of a mania. There are too many buyers for a limited number of shares and those buyers don't care about the fundamentals of the company. All they care about is owning Apple no matter the cost. Whether it is Apple buying back its own stock, index funds being forced to buy more Apple shares as they get more fund inflows, or Robinhood investors that have yet to learn the painful realities of valuation, all of them will buy Apple stock no matter the price.

The same goes for Tesla which is a company that just barely breaks even on $25 billion of revenue. Yet, the company is valued at $373 billion. So this means if you are an investor and you think that Tesla can grow its revenue by 10 times (which is crazy) and that it can generate a 10% profit margin (which is high given the auto industry averages 5% or less), you could possibly earn a 6.7% return on your investment sometime in the future. That is just nuts! Why would I want to take all that risk at the unlikely chance of earning a 6.7% return some years down the road?

One of my favorite investors to follow is John Hussman. The man is a financial genius having figured out a way to model future returns of the U.S. market. You can follow his work by reading his monthly commentary here

His most strongly correlated model is one that looks at the 12-year return of a conventional mix of investments (60% U.S. stocks, 30% treasury bonds, and 10% treasury bills). He has this thing dialed into a 93% correlation, which is incredibly high [side note: the Federal Reserve's own model is only 30% correlated which John Hussman has proven (see here for a range of models he has tested)].

As the graph I included above shows, the anticipated future 12-year return according to this model just hit an all-time low of -0.73%. This is lower than any other time in the last 100 years including the 1929 bubble that preceded the Great Depression. This also means that investing today at these valuations will almost guarantee a loss over the next 12 years on your investment. Don't let your inner fear of missing out drive you into investing at these crazy high valuations.

If you are a long term holder with a set it and forget strategy, keep doing what you're doing. If you are trickling money into the market with a 401K or some other savings vehicle, keep doing what you're doing. But if you have a lot of cash on the sidelines and want to jump into the market, be very careful right now. Hussman's forecast suggests that you'd actually earn more over the next 12-years by keeping it in cash.

Plus if and when the market does decline, you can buy in at a better valuation level at a time when the projected returns are at least positive and ideally 5% or greater as has been the case over most of the last 100 years.

The other fascinating thing to see is if you are kicking yourself for not having invested back in March or April 2020 at the height of the global pandemic, take a look at the graph. See that spike that didn't even make it to the 2.5% line? That is where valuations got. The market was still overvalued even at that time. You did not miss anything. Stay patient. There will likely be a better opportunity to enter the market in a material way in the coming months/years.