Written by Lance Roberts, Clarity Financial
The problem is the market surged higher due to the ongoing liquidity injections from the Federal Reserve. While liquidity drives asset prices higher, it does not foster economic activity, which creates corporate revenue.
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Currently, the price-to-sales (revenue) ratio is at the highest level ever. As shown, the historical correlation suggests outcomes for investors will not be kind.
Of course, given that revenue can only grow roughly as fast as the economy, the market-capitalization to GDP ratio is very important. While the “price” of the market can outpace economic growth in the short term, it can’t do so indefinitely. Thus, at 2.4x economic growth, the market is highly overvalued relative to what the economy can generate in revenue growth.
Lastly, with markets currently perched near all-time highs, both operating and reported earnings will fall in Q2 versus Q1 as economic growth peaks. (We have repeatedly warned of this issue.)
Note that as of Q2-2021, operating earnings (earnings without all the bad stuff) will only be 10% higher than they were in 2018. Yet, the market is currently trading 48% higher.
Even with the “sharpest recovery in earning in history,” the market continues to expand its valuation multiple. (Chart below uses current estimates for Q2-2021) So much for earnings catching up with the price.
As I said, investors have priced the market for perfection. Therefore, any disappointment could lead to poor outcomes for investors taking on excess risk.
Portfolio Update
I wanted to wrap up today’s note with some comments from my colleague Doug Kass on “Lessons Learned & Relearned.” As investors, the market has a habit of teaching us we aren’t as smart as we think.
* We learn from history, which usually rhymes.
* Liquidity is an overriding market force and influence as markets are a function of demand versus supply. The size of the Fed’s balance sheet will have an overriding impact on the markets. But the reduced supply of equities also is an important part of the investment equation. (There are about half the listed companies compared to what existed two decades ago. Of the companies still listed, more than 25% of outstanding shares are retired).
* A market in motion tends to stay in motion. Higher valuations usually beget higher valuations (and vice versa). A bona fide (and correct) contrarian view is a low probability practice. But, when the contrarian is correct, it can deliver large payoffs.
* Markets and emotions often go to extremes. Importantly, mean regression is a powerful force and consistent feature in the market.
* Seek precision when playing chess but not when investing.
* The notion, held by some, that the direction of the broad markets is a function of the health of speculative stocks is grossly incorrect. Crap doesn’t lead except for brief periods of time.
* It is fine to take chances and make mistakes. However, while it might work briefly, it is foolish to trade stocks with admittedly little value simply because they are moving higher.
* Avoid “group stink” as it can be harmful to your investment well being“
The risk of a correction is high but not necessarily immediate.
Manage your risk accordingly.
Have a great week.
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