Equities in Nosebleed Territory
The U.S. stock market, the biggest in the world, continues to notch record gains, and this is making investors nervous. Is the stock market overvalued or are investor fears unfounded?
According to a recent survey, approximately 36% of investment managers think the U.S. stock market is undervalued or fairly valued at current levels. To put that into context, that’s the lowest reading in the history of the survey. On the other hand, nearly 65% of investors believe U.S. stocks are overvalued. That’s the highest percentage on record.1
Interestingly, the survey was conducted over a period that ended June 22. Since then, the S&P 500 has advanced another 1.5%.
What points to the U.S. stock market being overvalued, and should investors be afraid of a stock market crash or a serious correction?
Trump Bump Is Slumping
Before the November election, analysts were predicting that a Donald Trump victory would send the stock market reeling. But the opposite happened with stocks enjoying a big bump in the months following the election. Investors decided that President Trump’s pro-growth, pro-business policies would be great for corporate America and help reverse the weak economic trajectory seen under then President Barack Obama.
Since November, the S&P 500 has hit a number of records and is up more than 14%. Over the same period of time, the Dow Jones Industrial Average has advanced nearly 16% and the NASDAQ has climbed a whopping 22%.
Again, stocks surged following the election because investors believed in Trump’s economic policies. Unfortunately, Trump’s proposed tax cuts have not been implemented. It was originally hoped that the Trump administration would have something passed by August; that time line has been pushed back to the end of the year.
GDP Data Remain Weak
Stock markets are only as strong as their equities. And rising stock prices can only be reliably supported by strong revenue and earnings growth. Unfortunately, Wall Street has been relying on the Federal Reserve’s artificially low interest rates to fuel stock market growth.
The bull market is now in its ninth year, making it the second oldest in history. But it’s important to understand that the current economic recovery is advancing at the slowest pace since World War II.
During the Obama administration, annual gross domestic product (GDP) growth averaged two percent. In the 10 previous expansions, GDP advanced 4.3% on average. In 2016, Obama’s last year in office, GDP growth was 1.6%.
That underwhelming trajectory has continued into 2017. In the first quarter, U.S. GDP increased at a 0.7% annual rate, the weakest pace in three years. The second-quarter outlook remains weak, too.
Because of weak economic data, the typically optimistic Atlanta Fed has lowered its second-quarter GDP guidance to 2.5%. In May, the Atlanta Fed was predicting second-quarter GDP of 4.35%.2
Meanwhile, the New York Fed revised its second-quarter GDP outlook downward. It expects second-quarter GDP to come in at two percent; that’s down from the projection of 2.6% announced in April.3
Stock Market Valuation Sky High
The most popular metric that looks at stock market valuation points to stocks being significantly overvalued.
According to the cyclically adjusted price-to-earnings (CAPE) ratio, the S&P 500 is overvalued by 87.5%. The 10-year average ratio is around 16. It is currently at 30.28.
That means for every $1.00 of earnings a company makes, investors are willing to shell out $30.28. The ratio has only been higher twice: in 2000, at the height of the dotcom bubble, and in 1929, right before Black Tuesday. In each case, a stock market crash followed the high valuation.4
The fact is, stocks continue to be supported by the Trump Bump, which is based on Trump getting his tax cuts and infrastructure spending implemented—neither of which has happened.
This will make it extremely difficult for Trump to achieve his campaign promise of sustainable annual GDP growth of three percent. It will also make it virtually impossible for the S&P 500 to deliver double-digit earnings-per-share (EPS) growth in the second half of 2017. Over the last number of years, S&P 500 companies have delivered average EPS growth of just 5.6% in the second half of the year versus the first half.
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The euphoria that swept Wall Street after Trump won the U.S. election, sending stocks to record levels, can only support the markets for so long. Eventually, investors will want to see real earnings growth. If that doesn’t happen, stocks will experience a serious correction. Thankfully, the licensed industry professionals at Learn-To-Trade.com can help investors profit even if overvalued stocks eventually crash.
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- Vlastelica, R., “Two-thirds of U.S. investors think stocks are overvalued,” MarketWatch web site, July 21, 2017; http://www.marketwatch.com/story/two-thirds-of-us-investors-think-stocks-are-overvalued-2017-07-21.
- “GDPNow,” Federal Reserve Bank of Atlanta web site; https://www.frbatlanta.org/cqer/research/gdpnow.aspx?panel=1, last accessed July 24, 2017.
- “Nowcasting Report,” Federal Reserve Bank of New York web site; https://www.newyorkfed.org/research/policy/nowcast, last accessed July 24, 2017.
- “Online Data Robert Shiller,” Yale University web site; http://www.econ.yale.edu/~shiller/data.htm, last accessed July 24, 2017.