Q&A: Has The Stock Market Reached a Top?
There’s always a tug-of-war between the bulls and bears, but the coronavirus pandemic has made these competing tensions even more intense.
On the one hand, the bull market confers huge opportunities for making money. And yet, stocks are overvalued and the risks of a correction are growing. To explore this dilemma, I recently chatted with my colleague Amber Hestla [pictured].
Amber Hestla is the chief investment strategist of Income Trader, Profit Amplifier, Maximum Income, and Precision Pot Trader. She’s an expert at devising “defensive growth” strategies that are suitable for the current good news/bad news investment environment. My questions are in bold.
Stocks hover at record highs, as investors are cheered by the likelihood of imminent fiscal stimulus as well as improving corporate earnings. The inauguration this week of Joe Biden as president also has released “animal spirits” on Wall Street. It begs the question: are stocks overvalued and poised for a correction?
I think we’re approaching a market top. Major stock market averages continue reaching new highs. That’s usually something we see either when earnings are rising or the stock market is topping. It’s more than likely we are seeing the latter event unfold.
I’ve put together a chart of earnings per share (EPS) estimates for the stocks in the S&P 500. The blue line shows 2020 and the orange line shows the current year.
For perspective, my next chart shows the price-to-earnings (P/E) ratio for the S&P 500 based on estimates.
Based on trailing earnings, the index has a P/E ratio of 32. Based on expected earnings, the ratio hovers at a more reasonable 25, but it is still a premium to the long-term average of 17.
But interest rates are at historic lows. Doesn’t the Federal Reserve’s ultra-dovish monetary policy justify these relatively high P/E ratios?
Yes, interest rates are low. In fact rates on 10-year Treasury notes are below the rate of inflation. The result is negative real rates, as shown in the following chart of the 10-year Treasury inflation protected security.
Negative real rates are generally caused by central banks. The Federal Reserve wants to increase inflation and does this by holding down interest rates. This means that low interest rates are engineered by the Fed rather than a natural source of information for markets to evaluate.
In other words, it’s entirely possible interest rates should be higher and would be if the Fed wasn’t intervening in the market. Investors relying on the argument that low rates justify overvalued markets are underestimating this reality.
If rates settle at a level where the market believes they should be, instead of an artificially low level dictated by the Fed, stocks would most likely crash. I don’t expect to see that happen soon, but I do believe caution is called for.
How would you characterize the economic recovery? We certainly can’t describe it as “V-shaped.”
Unemployment remains elevated, especially among lower-wage workers. The economy continues to demonstrate characteristics of a “K-shaped” recovery, which is one where different parts of the economy recover at different rates. That means there will be significant trading opportunities in the coming months.
Looking ahead, the stock market is likely to break out of its trading range as the political environment in Washington becomes more certain. For now, the short-term outlook remains bullish based on the price action.
The SPDR S&P 500 ETF (SPY) ended 2020 at a new all-time high on a closing basis. Since the November 3 election, we’ve witnessed a remarkable stock market rally.
But as I mentioned earlier in our discussion, stocks are currently overvalued. Stay invested, but stay on your toes.
Editor’s Note: As my colleague Amber Hestla makes clear in the above Q&A, investment risks still lurk around the corner. More than ever, you need to be selective with the stocks you buy.
The economy is improving, stocks are rallying, and the roll-out of vaccines provides hope that we’ll get the coronavirus pandemic under control. But we’re not out of the woods…not by a long shot.
That’s why our investment team has put together a special report: “5 Red Hot Stocks to Own in 2021.” In this report, we provide the names and ticker symbols of the highest-quality stocks to own for the new year. Click here for your copy.