What Does the High Stock Market Mean for Investors?

Overvalued Stock MarketThe S&P 500 and NASDAQ are at record levels, and investors remain bullish. But is their optimism misplaced in an overvalued stock market? In the face of mediocre earnings, will this ballooning optimism lead to a stock market crash?

Stock Market and Investor Optimism Remain High

The stock market celebrated its six-year anniversary in March and investors couldn’t be happier. Since bottoming in March 2009, the S&P 500 has soared more than 215%, the NASDAQ is up more than 290%, the NYSE has climbed more than 165%, and the Dow Jones Industrial Average has advanced more than 175%.

By the looks of things, investors think the stock market has a lot of room to run. During the first quarter, investor optimism surged 21 points to reach +69 in February—the highest level since 2007. The 21-point increase since November 2014 is the biggest quarterly gain in two years. (Source: Wells Fargo & Company, March 5, 2015.)

Investors, it seems, are increasingly optimistic about the economy and their personal finances. The majority (58%) said it was a good time to invest in the markets, down slightly from the 56% that said this at the end of 2014, but up from the 52% that said the same last July. During 2011 and 2012, the majority of investors said it was not a good time to be in the markets.

This Says the Stock Market is Overvalued

Maybe investors are a little too optimistic.

The cyclically adjusted price-to-earnings ratio (CAPE) for the S&P 500, which is based on average inflation-adjusted earnings from the previous 10 years, is sitting at 27.24. This suggests the S&P 500 is overvalued by 70%. The last occasions the markets were this overvalued were in 1929 (the Great Depression) and 1999 (the dot-com bubble burst). (Source: yale.edu, last accessed May 5, 2015.)

Yale Chart

For further evidence that overly optimistic investors are dragging the stock market higher, we just need to look at the Total Assets Rydex Bear Index Funds. The fund tracks assets in bearish stock market funds. Today, funds that hold a bearish view on the stock market are at their lowest level in more than 15 years. (Source: stockchart.com, data set, “Total Assets Rydex Bear Index Funds,” last accessed May 5, 2015.)

Total Assets Rydex Bear Index Funds Chart

Chart courtesy of www.StockCharts.com

These Stock Market Trends Also Point to an Overvalued Market

For stocks to climb higher, investors need to have a reasonable expectation that revenue and earnings will grow consistently with economic growth. I’m not so sure we’re seeing that either.

As noted, the markets are at or near record highs. Granted, the markets have been a little choppy since the beginning of the year, but they’re still holding strong. The record levels seem to be out of step with earnings.

Of the 360 companies on the S&P 500 that have reported first-quarter earnings, 71% have reported earnings above the mean estimate; that’s lower than the five-year average of 73%. Oddly enough, even though a solid number of companies are reporting earnings growth, just 46% are reporting revenues above the mean estimate; that is below the one-year average of 59% and the five-year average of 58%. (Source: FactSet, May 1, 2015.)

If 46% stands as the final percentage for the quarter, it will mark the lowest percentage of companies reporting sales above estimates since the first quarter of 2012 (41%). Since the third quarter of 2008, the percentage of S&P 500 companies reporting sales above estimates has only been below 50% six times.

Overall, the blended earnings decline for the first quarter of 2015 is -0.4%. Looking ahead, for the second quarter, analysts are forecasting year-over-year decline in earnings of -3.6% and revenues of -4.4%. In the third quarter, earnings are projected to fall -0.1% while revenues will fall -2.3%. Things are only expected to turn positive by the fourth quarter with earnings up 5.4% and revenue up a measly 0.3%. For fiscal 2015, analysts project earnings to grow by just 1.6%, but revenues to decline by 2.0%. (Source: FactSet.com, April 24, 2015.)

In light of this, the S&P 500 continues to hold on to gains. But it could get more difficult to keep the bull market running. Almost half of all the companies listed on the S&P 500 derive earnings from Europe and Japan (barely growing), China (slowing), and even Russia (deep recession). The strong U.S. dollar will also exacerbate the situation for U.S. stocks and could hobble economic growth.

Protecting Your Portfolio from the Downside

The unfortunate part of an overly optimistic investor base is that few are prepared for any sort of stock market correction, let alone a crash. In fact, the majority (67%) of investors say they lack a plan to protect their investments should the markets experience another severe downturn.

A balanced investment portfolio should have some downside protection. This could include Treasures and high quality bonds. It could also include precious metals, either physical gold and silver; stocks; or ETFs.

Investors may also want to consider high-quality dividend-paying stocks. Many do well in the midst of rising interest rates—which the Fed is expected to do later this year.