According to a variety of valuation metrics stocks have only been more expensive than they are today on two occasions: the 1929 stock market bubble and the 1999 stock market bubble. Relative to history then I think it’s safe to say that stocks are “very expensive” (aka, very risky) at current levels.
But this is not what Wall Street would have you believe. Wall Street only makes money when you, the retail investor, are a buyer so to keep you buying they play a shell game with both earnings and valuations to keep you hitting the buy button. One way they do this is to focus your attention on stock prices relative to “forward earnings” – a fancy term for analysts’ predictions for what companies will earn in the future.
Below is chart of the S&P 500 compared to “forward earnings” (via Crossing Wall Street). I’ve seen charts like this popping up everywhere lately.
It looks great; doesn’t it? This chart makes it look like stocks should keep going up forever.
The problem is that this chart looked just like this at the 2000 and 2007 stock market tops just before stocks fell roughly 50%. So what gives?
Well, near market peaks investors tend to forget that everything, including the economy and the stock market, works in cycles and, in the words of the Federal Reserve, they, “extrapolate recent price action [or economic action] far into the future.” (This quote comes from a study the Fed did to determine how bubbles are formed.)
What analysts know and should prevent them from ‘extrapolating the recent earnings growth far into the future’ is that outside of financial companies, earnings growth actually turned negative last quarter. What’s more the strength in financial companies’ earnings is based on bogus accounting (reduced loan loss reserves are not real earnings and portfolio losses from rising interest rates are no longer reported). To my mind this makes these “forward earnings” numbers nothing more than hope… and you know what they say about hope as an investment strategy.
Professional investors understand this and I believe it’s the reason they’ve taken the opportunity over the past four weeks to dump a massive amount of equity exposure onto retail investors who are suddenly eager to buy both the Wall Street fairy tale of “forward earnings” and the stocks they are selling in the telling.