Valuations remain at or near their highest levels in history, corporations continue to add to their record debt loads, and inflation is proving to be non-transitory, cautions Jim Stack, money manager and editor of InvesTech Research.
In comparison to the Tech Bubble peak just over twenty years ago, this is a very different economy and stock market, but not necessarily in a good way.
On the positive side, the U.S. forecast for GDP this year will be 120% higher than in 2000 — $22.7 trillion versus $10.3 trillion. While on the not-so-positive side, the stock market has increased by 233%, making this the most overvalued stock market in Wall Street history by almost all valuation metrics.
Of course, driving these valuation and speculative extremes has been the most accommodative Federal Reserve policy in U.S. history. Currently, short-term interest rates are near 0% as compared to 5.5% at the peak of the Tech Bubble.
And since the pandemic hit, the Fed has added $4.5 trillion to its balance sheet in bond purchases — almost four times their balance sheet expansion (stimulus) during the Great Recession in 2008.
At $49.0 trillion today, stock market capitalization has increased +$14.5 trillion from pre-pandemic 35 levels — nearly the same amount as the total value of the stock market at the 2000 Tech Bubble peak! For most seasoned investors watching the speculative craziness, these feel like nose-bleed levels.
There is no denying that the leading macroeconomic evidence appears strong, yet it's worth noting that there can be too much of a good thing when it comes to economic growth — at least as it relates to Fed policy and the stock market outlook.
When the Leading Economic Index (LEI) rises 7% beyond its 18-month moving average, as it did in July of this year, the S&P 500's forward returns are mostly negative on average, including losses a year later in the majority of prior instances. It's also notable — and worrisome — that in 3 of the 4 prior instances a bear market or sharp 15% correction started within six months after such LEI strength.
The message is similar when looking at S&P 500 returns following very strong readings in the ISM Manufacturing Index. Bottom line, strength in the leading macroeconomic evidence is a positive confirmation for the economic recovery and our current benefit of doubt, but that does not necessarily translate into blockbuster equity returns or even a bullish outlook.
Today’s market environment is high risk in terms of extreme valuations, speculative excesses, and the probability of structurally higher inflation.
Our more conservative approach may or will leave profits on the table if the market moves higher. However, being preemptively defensive is critical to help navigate the downside risk. In a market like this, return OF your capital can be more important than return ON your capital.