When I look at the stock market, I am worried. I see investors behaving like they do when markets are at their peaks or forming a top. I see irrationality, extreme valuations, and too much optimism among investors.
Investors Buying Everything and Anything?
Do investors really care about what they are buying these days when it comes to stocks? In just the last few months, I have seen companies do initial public offerings (IPOs) without any earnings in sight. And investors are lining up and paying top-dollars for them… Reminds me of the Tech Bubble of 1999 all over again.
Did you hear the story about the company called The Grilled Cheese Truck, Inc. that trades on the over-the-counter (OTC) exchange? Currently, this company’s market capitalization is $72.0 million. Digging deeper, this company doesn’t have enough cash to pay its ongoing bills. Its liabilities far exceed its assets. (Source: The Grilled Cheese Truck, Inc., last accessed February 18, 2015.)
How is this rational? A company worth zero is getting a $72.0-million valuation. There are so many examples of companies like this out there that investors are naïvely buying.
Valuations Beyond Reality
One key stock market valuation tool I look at is the CAPE ratio of the S&P 500. It’s the price-to-earnings (P/E) ratio adjusted for inflation and cycles. Currently, this ratio stands at 27.6. The last time this ratio was near this level was in 2004. Comparing the current valuation of the S&P 500 to its historical average of 16.59, the stock market is currently overvalued by 66%. (Source: Yale University, last accessed February 18, 2015.)
Next, to give you some idea about how much optimism there is out there amongst investors, please look at the chart below. It displays assets in the bearish stock market funds and gives us an idea about what investors think.
As it stands, funds that hold a bearish view on the stock market have the lowest assets since 1998. In other words, optimism is extreme and investors have no fear the stock market will fall.
Chart courtesy of www.StockCharts.com
Are We at a Stock Market Top?
While history tells us what happened when key stock indices peaked in the past, it also teaches us that it can be impossible to predict a market top.
As I see it, the unprecedented actions of the Federal Reserve (printing so much new money, keeping interest rates near zero for years) and the government (increasing its debt load by trillions since the Great Recession) have extended the stock market above normal and acceptable historical valuations.
I know the market can remain irrational for long periods of time (especially when the Fed is on its side), but when the market does come back to reality (and it will), it won’t be a pretty sight for the investors who have bid stock prices higher.