The stock market's valuation suggests that near-term gains are possible but that a correction will eventually tank share prices.
Most stock market participants agree–this bull market is trading on the promise of an economic recovery and stimulus money. Low cost, commission-free trading brokerages like Robinhood made it possible for anyone to become a speculative day-trader. That has triggered a rally of epic proportions.
But is it sustainable? How much longer can the Fed and overzealous traders shoulder the burden of an overvalued market?
The Fed recently announced it would start buying individual bonds even though the bond market looked relatively healthy. The announcement helped investment-grade bond ETF LQD rise to all-time highs. As Bloomberg’s John Authers put it, the decision was unnecessary and has a glaring undertone: keep the stock market from crashing.
Barstool Sports’ David Portnoy and his millions of followers saw their bizarre investments continue to rise. Portnoy’s running stock market commentary has become somewhat of a caricature of the current mood among today’s investors: buy anything with letters and it’ll go up.
Portnoy even declared himself a better investor than Warren Buffett. The thousands of furloughed workers that plowed their stimulus checks into the stock market agree. That’s true for anyone who’s investment track record spans just four months.
But Buffett’s experience is likely what’s keeping him on the sidelines. That’s because, eventually, share prices have to align with fundamentals. When that happens, it’s going to be a bloodbath.
Peter Cecchini, a former Cantor Fitzgerald strategist, says the flood of new traders has created “an unholy speculative mix.” He noted that Portnoy and his followers seem to be convinced that stocks will always rise. That sentiment has been confirmed by the Fed’s commitment to propping up the market.
[Congress and the Fed have created] an unbreakable cycle of addiction to not only monetary policy but also fiscal policy. […] This may be the reason why David Portnoy just thinks stocks go up and up … can he really be serious?
Cecchini says that kind of risk-taking is evidence of a looming correction.
But the big question is when. For investors like Warren Buffett, who’s been looking worriedly at the lack of concrete data to trade on, this rally has been a missed opportunity. Some point to the most recent non-farm payrolls data as tangible evidence of a recovery.
But John Hussman, president of the Hussman Investment Trust, warned that the payroll data are simply a product of the government’s stimulus:
What we are observing is not ‘recovery,’ it’s the impact of a government program that is paying the salaries of employees that are kept on payroll, whether they are actually working or not.
Hussman says his valuation model shows the stock market’s value is nearing dot-com bubble levels. By that metric, the S&P 500 could lose 66% of its value in the coming months.
Despite that, Hussman says not to discount the power of Portnoy and his band of merry traders. In the near-term, the market could keep rising. Especially if the Fed continuously rewards speculators:
Despite these headwinds, the repeated series of bubble-crash cycles of recent decades teach that there is no natural limit to the stupidity of Wall Street. When investors get the speculative bit in their teeth, it’s fine to be neutral, but it’s best not to fight the speculation by adopting or amplifying a bearish outlook
Now, investors have to decide when their fear of losing outweighs their desire to ride this rally. At the end of the summer, several potential downside catalysts could spark another selloff.
This scenario is one that Buffet has preached for decades. Be greedy when the market is fearful and fearful when the market is greedy. Soon, investors will have to weigh whether or not share prices are based on reality or greed.