A New Era

Most investors will agree that the market is overvalued.  A recent survey by BA Merrill Lynch stated that 78% thought the market was overvalued.  But they think the market will go up because of the Fed and all the liquidity, and they think they can get out and sell to the greater fool.  Yeah, its become the greater fool theory for stock investing now. 

These stock valuations are justified by low bond yields, they say.  As if Japan and Europe don't have even lower bond yields, and yet their equity markets are cheaper.  So there is a big hole in that theory.  New ways of rationalizing a very expensive market with deteriorating earnings.  Earnings yield being much greater than 10 year Treasury yields.  So in theory, if rates go to zero, stock valuations should go to infinity.  Why hasn't that happened in Japan and Europe? 

New era thinking in the stock market always arises after an extended bull market.  You saw that in the 1960s and 1970s with the Nifty Fifty stocks that were going to take over the world with all their conglomerates.  Then you saw the biggest stock bubble ever, in 1999-2000 when technology was so great that it justified a huge premium over other sectors. 

You are getting that now with the SaaS stocks and the Big Five:  MSFT, AAPL, AMZN, GOOG, and FB.  It's almost as if the pandemic just proved that these stocks are invincible, and thus justify and even higher earnings multiple.  Its almost as if these companies don't rely on business investment or correlate with the macro economy.  They are treated as islands, safe havens in the storm of the normal business cycle.  Or maybe some of these investors think that the business cycle has been eliminated by the Fed, and its now a permanently high plateau. 

I guess I am too old fashioned, like Warren Buffett, and still think that these loved tech stocks are cyclical companies, and that their valuations are ridiculous. You have new guys in the stock market thinking they own the place, like Dave "Davey Daytrader" Portnoy, who suddenly is the most famous stock trader in the world.  And he picks his stocks using letters from Scrabble. 

About the Fed liquidity argument for justifying high stock market valuations, let's look at China, who's M2 money supply has gone through the roof over the past 25 years, and what the Shanghai Composite has done over the same time period:

China M2 from 1997 to 2020 (up ~2000%)

Shanghai Composite from 1997 to 2020 (up ~140%)

So obviously the correlation between money supply growth and stock index levels is not that high. In China, money supply growth is about 10 times stock index growth over the past 23 years.  All the money has gone to real estate, not equities. 

I can picture a similar scenario in the U.S., where most of the money that is printed by the Fed ends up in real estate, which is a hard asset, rather than a soft asset, like stocks which is overvalued and also subject to earnings manipulation and accounting trickery, which is quite commonplace now.  Also, if stock valuations stay high, I can definitely see a lot more equity supply coming out to feed the ducks. 

Contrary to what many think, the best investment in the US is real estate, not stocks.  They are not building enough starter homes to meet the demand, and last I checked, the US population is one of the fastest growing populations in the developed world.  So the demand will be there.  New supply is constrained by the lack of land in good locations near the big cities. 

If the Fed keeps printing money like it has this year, which is the most likely scenario, I can definitely picture the SPX going into a long sideways to down market and real estate prices keep going up. 

During a few of the trading days last week, we had sudden SPX dips intraday on news of growing coronavirus cases in AZ, TX, and FL.  In the past, these sudden dips that recover are an omen of a bigger move lower.  Its like a boxer throwing body punches and while they don't result in a knock out, they wear down the opponent and set up a knockout for the later rounds.  Those sudden dips that you saw last week and even this week overnight on Monday and Tuesday are like body punches.  They accumulate and wear down the bulls.  Even though we've gone sideways for the past few days, the market has softened the belly of the bulls.  In these cases, usually a knockout punch to the head is coming soon after.