There is a significant amount of evidence that suggests stock market valuations are stretched to the extreme. Even the Fed thinks the market is expensive.
Federal Reserve Concerned About Stock Market Valuation
On February 24, 2015, the Federal Reserve issued its semi-annual monetary policy report. In this report regarding the stock market, word-for-word, it said, “Overall equity valuations by some conventional measures are somewhat higher than their historical average levels, and valuation metrics in some sectors continue to appear stretched relative to historical norms.” (Source: Board of Governors of the Federal Reserve System, February 24, 2015.) This is the second time the Federal Reserve has said something like this.
The Fed’s statement should be taken as a sign of caution. Back in 1996, former chairman of the Federal Reserve Alan Greenspan said that stock market valuations were stretched. A few months later, key stock indices witnessed a sell-off and didn’t recover until much later.
But investors aren’t worried about the Federal Reserve’s gentle warning on stocks. Minutes after this report was released, the stock market rallied! Look at the chart below—moments after this report was issued, the S&P 500 jumped from negative to positive
Chart courtesy of www.StockCharts.com
Economic Misery Remains an Issue
The Federal Reserve’s warning about the stock market isn’t the only thing investors are ignoring. It’s like they have stopped caring about economic data, too. When you look at the economic data, it is gruesome. A significant amount of poor economic data is being ignored by investors.
For example, existing-home sales data. The National Association of Realtors reported that the sales of already-built homes in the U.S. economy declined 4.9% in the month of January from the previous month—down to an annual rate of 4.82 million homes from 5.07 million homes in December. Sales of existing homes have now fallen to their lowest level since April of 2014. (Source: National Association of Realtors, February 23, 2015.) Forget the fact that analysts had expected home sales to come in much stronger than they did.
In the month of February, key economic data released, like retail sales, personal spending, auto sales, consumer sentiment, homebuilders’ sentiment, industrial production, and several other economic indicators, all came in well below expectations—and investors just pushed stock prices higher.
Caution Is the Best Investment Strategy for Stock Market Investors
The stock market is running on irrationality and false hope.
Key stock indices cannot continue to move higher forever. The valuation of public companies and economic conditions do match. Only at times when we are nearing a market top, like we are now, are investors willing to pay top-price for stocks.
I continue to preach caution and preservation of capital. From my years of experience, key stock indices climb the wall of worry slowly, but the move to the downside is often unexpected, fast, and vicious.