The Perils Of Remaining In An Overheated Stock Market

As the DOW passed the magic  22,000 mark,  millions of stock investors began salivating at the prospect of  continued humongous gains - filling their 401ks or IRAs.  But most are barely aware of the treacherous territory they've entered.  Most had never  seen or read Nate Silver's book, The Signal and the Noise- Why So Many Predictions Fail But Some Don’t  - especially where he warned (p. 347):

"Of the eight times in which the S&P 500 has increased at a rate much faster than its historical average over a 5-year period , five cases were followed by a severe and notorious crash, such as the Great Depression and the Black Monday crash of 1987”.

Interestingly, two of the largest stock market dives have followed two of the biggest bubbles: the first of 37.85 percent and on the heels of the bubble that formed from Jan. 14, 2000 to Oct. 9, 2002, and the second of 58.78 percent that formed (mainly due to the housing bubble) from Oct. 9, 2007 to March 9, 2009.

One indicator of a bubble, of course, is the rate of stock  share increase. But another is the rate of inflation related to the trailing P/E ratio.  This is the classic price to earnings which looks at the current price divided by the company's total earnings the past 12 months. .  This is perhaps the most common metric used by investors to value publicly traded companies. While it does not account for growth rates by default, it represents a simple metric that can be compared over long periods of time. Lofty P/E multiples can predict market declines when growth starts to slow down, since investors can no longer justify the higher valuations.

Well, we are in that territory now. For reference, three years ago (in September)  the P/E ratio was about 18.5. Today the P/E for stock in the S& P 500 index is just over 24.  That is, investors are paying $24 for each $1 in corporate earnings. Just before the 2008 crash and 2009 financial meltdown it hit 27.   

What about those profits? Back in September, 2014, the profits for all the companies in the S & P 500 index were about $106 a share.  Currently, we're in the midst of second quarter earnings reports for 2017 and the estimate is that the same S & P 500 profits will be coming in at about $105 a share. That means profits haven't grown at all in three years - and yet the price of the S & P 500 is up about 23 % over the same period.

What gives?   What gives is that there is no genuine support for the share increases or higher PE ratio.  In other words, people are basically being hosed. Let's also note the long term average pE ratio is about 16 and markets tend to revert to that average at some point.

The other aspect is there is no really solid backing to justify the spiking DOW or sizzling S & P 500. The corporate earnings, profits simply don't support it. This is also why there exists a divergence between what we ae seeing with the stock market, and the low growth and wage stagnation plaguing Main Street.

But we were warned of this before. As the authors (William Wolman, Anne Colamosca)  of The Great 401 k Hoax have noted, it is living in a fool's paradise to believe that if the companies you invested in are only increasing their profits at 2-3% a year, that you can be earning 7% or even 10%. In fact, what one has then is an aberration in which the gains are out of whack with reality. (This is one reason why real stock investors demand dividends, and refuse to forego them so fund companies etc. can use the money to do "stock buybacks" thereby artificially inflating the share price!)

Why is this perilous? Some might ask. Consider: though you may be exuberant now to be getting near 10 percent returns, what if the market suddenly reverts back to the more standard 7 percent?  Doing the math it means you would need to save 70 percent more money to get to the same place as you have with the 10 percent returns.   Translated to income saved to pay for mutual funds or stocks, this means if you are taking out 5 percent now - say $150 a month - you will need to shell out $255 in the 7 percent return environment.  Obviously, if the returns go even lower - say to 5 percent or less- the savings burden will increase as well.

Simply put, the notion that you can save less because the market will do most of the heavy lifting is a fool's errand and paradigm. It won't. In fact, you will be in a hell of a lot worse position if the market tanks - say in a 20 percent correction. To get down to even more severe (e.g. crash) cases, a stock – or mutual fund- that drops in share price from $20 to $10 has suffered a 50% loss. But for that $10 stock or fund share price to return to $20  (breakeven point) it must gain 100%, or double.  Those near retirement need to ask themselves if they can sustain such a loss, and to multiple stocks or funds.

The other phantom contributing to the inflated PE ratio accompanied by low corporate profits, is stock buybacks which I've written about before.  The question every investor ought to ask is: WHY should Company X or Y have to buy back its own stock to create an artificial rise in share price if your company is genuinely doing well? It makes no sense. If Company X or Y is going to use any extra money for anything it ought to be for paying dividends, not stock buybacks!

Columnist Jonathan Clements in his piece in the WSJ three years ago wrote:

"Many companies were big buyers of their own stock before the 2007-09 market decline, only to scuttle their buyback programs during the market crash. In recent years with share prices up sharply they have begun to voraciously buy back."

And indeed they are doing it now more than ever.  Why not, because they are then reaping the bounty of their own high share prices? Buy backs also make management's stock options more valuable - so what better way to compensate the Street's honchos?  Strangely, all this has selectively blinded investors to the lack of dividends. As Robert Arnott, quoted by Clements, stated:

"Dividends are reliable, You cut them at your own peril - but you can cut a buyback and hardly anyone notices."

There's one more reason U.S. stocks are soaring which people ought to be aware of: According to the WSJ European investors are buying them up at a rate 25- 30 % greater than historical averages. You may cheer that our friends across the pond are helping us to this extent, but wait. What if they suddenly pull their money out, redeem all those shares, for whatever reason? 

It's time to think now more carefully than ever just where you're putting your money and why.