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The Stock Market Is Waving a Giant Red Flag. Will You Ignore This One Too?

Last Updated September 23, 2020 1:59 PM
Sam Bourgi
Last Updated September 23, 2020 1:59 PM
  • The S&PP 500’s price-to-earnings ratio has reached its highest level in almost two decades.
  • The benchmark index is nearing all-time highs, having recovered 43% from March’s bear-market low.
  • Volatility is gradually returning to its historically neutral range, a move that is generally positive for stocks.

The stock market’s miraculous recovery over the past two months comes with one nasty side-effect: extreme over-valuation risks.

S&P 500’s Frothy Valuation

By Monday’s open, the S&P 500’s price-to-earnings (P/E) ratio had reached 23.00 . In other words, the index is trading at 23 times forward earnings–the highest since mid-2001 .

The P/E ratio measures a company’s current share price relative to its per-share earnings. A high P/E often means that a market’s current price is not justified by its earnings outlook.

The elevated P/E comes even as many corporations revised or pulled their forward guidance due to the pandemic. As of Friday, 27 S&P 500 companies had issued negative earnings guidance for Q2 compared with 21 that issued positive guidance.

s&p 500 forward guidance
The S&P 500 Index is rallying despite a sharp downward revision to 12-month earnings expectations. | Source: FactSet 

Only 48 companies have issued forward guidance  for the second quarter, which is less than half of the five-year average.

An ‘Uncomfortable’ Rally

Stocks have rebounded more than 43% from their March lows thanks to unprecedented Federal Reserve intervention and optimism about a broad economic resurgence. The bulls were vindicated on Friday after the Labor Department reported a net gain of 2.5 million jobs in May .

As the S&P 500 inches closer to record highs, Allianz’s Mohamed El-Erian says the rally is making him “uncomfortable.”

The economist, who correctly predicted the pandemic-driven bear market, told CNBC :

For me personally, it’s an uncomfortable bet to continue to bet on a huge recovery… I don’t like doing this. But I respect and admire those who can.

Despite their ‘win-win’ attitude, investors are failing to consider the long-term impact of Fed intervention in the market.

Peter Schiff, twitter
Peter Schiff chimes in on El-Erian’s segment and warns of a massive inflationary cycle because of the Fed. | Source: Twitter 

The Fed’s balance sheet has been growing since September when the overnight repo market suddenly went haywire . But the pace of intervention has skyrocketed since March as all levels of government scrambled to prop up a sinking economy.

Federal Reserve balance sheet
The U.S. central bank’s balance sheet approaches an unprecedented $7.2 trillion. | Chart: Federal Reserve 

As the Fed’s liquidity boost keeps money flowing into the stock market, new all-time highs for the Dow and S&P 500 could be on the immediate horizon. In the meantime, the U.S. dollar could be headed even lower .

A measure of expected volatility is also returning to its historical mean, offering another sign that the worst of the market selloff has passed.

The CBOE Volatility Index, commonly known as the VIX, is back around 25 on a scale of 1-100 where 20 represents the average.

cboe volatility index
The CBOE VIX moves inversely with the S&P 500 Index about 75-80% of the time. | Chart: stockcharts.com 

VIX peaked in the high 80s in March as the S&P 500 crashed into bear-market territory.