- The U.S. stock market is overvalued.
- Earnings decline doesn’t justify the market’s rise.
- A correction could spark a meltdown.
The U.S. stock market has gotten off to a terrific start in 2020 despite scares that a crash might be around the corner amid rising tensions between the U.S. and Iran. The deescalation in tensions has prevented a full-blown war and created a tailwind for equities.
The Dow Jones is closing in on the 29,000-mark and analysts expect the stock market’s decade-old bullish run to continue in 2020. Invesco analyst Brian Levitt told Yahoo! Finance in an interview at the beginning of 2020 that:
I suspect the S&P 500 will end the year 10% to 12% higher than we are today… I am not expecting this to be a year where we are up 20%, 30%, but this is a year where markets should continue to move higher — and I would say the risk to that outlook is probably higher.
The analyst sees the Dow Jones at 35,000 at the end of the year, a jump of over 21% from current levels. But the reality could be much different if one thing is brought into consideration – the overvaluation of the stock market.
An overvalued S&P 500 is bad news
According to a report by Barron’s Nicholas Jasinski, the U.S. stock market is overvalued right now. What’s more, the rate of corporate earnings growth hasn’t been good enough to justify that overvaluation.
Consensus estimates project a 2.6% annual decline in the S&P 500’s earnings for the fourth quarter of 2019. If that happens, it would mark the fourth straight quarter of annual declines. That’s bad news for the stock market as the S&P 500’s forward price-to-earnings multiple has now increased to 19, Barron’s reports.
That’s higher than the 10-year historical average of 15. The alarming thing to note is that the valuation has increased despite a projected drop in the earnings of the S&P 500 components through 2019.
Companies have been resorting to buybacks to boost their bottom lines, but even that might not be enough to prevent earnings erosion for the fourth quarter. S&P 500 component earnings are expected to decline 0.4% for the fourth quarter of 2019 after accounting for share buybacks.
So far, a decline in the S&P 500’s earnings has not been a major deterrent for investors. The S&P 500 gained 29% in 2019, ignoring the tepid bottom-line performance that was on display. But the trend might change this year as the market expects 10% earnings growth from the S&P 500 in 2020.
A correction could spark a stock market crash
Stock market bulls can argue that a weak earnings performance is not necessarily the reason why the market crashes. They would be right in saying so as the S&P 500’s performance has generally been positive in the years that follow a bottom-line decline.
But things could turn out to be different this year considering the overvaluation of the S&P 500 and investors’ rosy expectations of strong earnings growth. The U.S. is already in the middle of an earnings recession and it might not be long before the gap between the valuation and bottom-line performance is covered – leading to a stock market crash.
That’s because U.S. companies could find it difficult to record earnings growth in 2020 on account of weakness in manufacturing activity, slumping consumer confidence, and a slowdown in GDP growth thanks to Boeing (NYSE:BA).
Treasury Secretary Steve Mnuchin recently said:
There’s no question that the Boeing situation is going to slow down the GDP numbers… Boeing is one of the largest exporters, and with the 737 Max, I think that could impact GDP as much as 50 basis points this year.
So, a potential stock market crash might be lurking just around the corner. A bunch of macro factors could keep the S&P 500 from attaining its projected earnings growth and lead to a correction.
Disclaimer: The opinions expressed in this article do not necessarily reflect the views of CCN.com.