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The Stock Market Is on a Collision Course with Reality & Not Even the Fed Can Save It

Last Updated September 23, 2020 1:59 PM
Laura Hoy
Last Updated September 23, 2020 1:59 PM
  • The stock market is the most expensive it has been in almost two years.
  • Earnings estimates don’t line up with current valuations, which could be a problem come Q2 reporting season.
  • Investors are banking on a fast return to normal, but so far their optimism is supported by nothing more than hope.

The stock market is insanely overvalued any way you slice it. The S&P 500 is trading at 22 times its forward earnings, the most expensive in nearly two decades. Stocks are roughly 6% off of all-time highs despite civil unrest in the U.S., a pandemic, and the highest unemployment rate the nation has seen in more than two decades. 

Unemployment, stock market, economy
The unemployment rate is still incredibly high despite Friday’s positive report. | Source: Trading Economics 

The Fed is Propping Up the Stock Market

There’s a simple reason for that: The Federal Reserve.

The central bank’s interference in U.S. financial markets has created an unprecedented backstop that has helped share prices continue to rise in the face of worsening guidance. Investors are counting on the Fed’s expanding balance sheet to build a bridge across 2020 and into the greener pastures of 2021.

Federal Reserve, the fed, stock market
The Fed’s ever-expanding balance sheet is good for stocks in the short-term. | Source: The Federal Reserve 

So far, the bank is making good on that promise—it’s balance sheet is currently nearing a whopping $7.2 trillion.

It’s clear that the Fed has the power to prop up the stock market. The adage “don’t fight the Fed” has never been more true than over the past three months. Now, the question investors should be asking is whether things will be as rosy as the market is pricing-in come 2021. 

S&P 500, earnings, stock market
The gap between the stock market’s current price and expected earnings is unbelievable. | Source: Twitter 

Fundamentals Out the Window

The S&P 500 has become completely detached from the fundamentals. That’s fine in the short term, but history tells us that the stock market always returns to the fundamentals.

The bulls are betting that when earnings become relevant again, they’ll have come up to meet the stock market’s sky-high expectations. The bears worry that it’ll be the stock market coming back down to earth. 

Washington Crossing Advisors’ Chad Morganlander says now’s no the time to be overly bearish. He’s firmly in the camp of those who see earnings climbing higher in the months to come :

Overall, we would advise investors not to be too bearish, at this point. Look at high-quality individual companies that don’t have a lot of debt on their balance sheet, and to be somewhat more critical in regard to that quality perspective

Kingswood Group’s Rupert Thompson is far more skeptical . He believes the stock market’s 40%-plus rally is too good to be true and that equity prices will come back down to earth in the near-term: 

[Markets are] now well ahead of the economic reality […] a correction remains on the cards over the coming months.

This rally, more so than any other, is one of faith rather than fact. The stock market has nothing concrete to hold it up or weigh it down. Improving jobs data sent a bullish signal, but the uncertainty of whether those job gains will stick is a concern for the future. 

Investors Pile into Stocks

It’s never been easier for retail investors to jump on board this rally either. Low-cost trading platforms like Robinhood have seen new user numbers explode as first-time traders pile into the stock market.

TD Ameritrade’s Investor Movement Index shows that clients were loading up on stocks in May after shifting away from equity exposure over the previous four months. 

stock market, ameritrade, invest
Ameritrade data show investors are snapping up stocks. | Source: Business Insider 

TD Ameritrade Chief Market Strategist JJ Kinahan said the market’s recovery has been incredible and unexpected . He points to the summer earnings season as the next big test for the stock market as it will give investors something more concrete to trade on:

My fear is that the reality of when we start getting real earnings. When we start getting back to earnings that mean something, that you can trade off of, the reality of the earnings may not keep up with the great optimism that we’ve seen.

Kinahan has a point—investors are standing on a Fed-built bridge skipping happily to the other side without knowing for sure what’s over there.

For now, the visibility of the U.S. economy in a post-pandemic world is relatively murky. Once companies start to issue reliable guidance, traders will have no choice but to confront reality. If it matches up to expectations, the rally will officially have legs. But an earnings miss could be catastrophic considering the exuberance in today’s stock market.

Disclaimer: The opinions in this article represent the author’s opinion and should not be considered investment or trading advice from CCN.com.