The Reality of Today’s Stock Prices

Four ways to measure the market… The most expensive moment in recorded history… Pay more, make less… There are no Holy Grail, magic bullets… Buffettology: stocks as bonds… Focus on buying high-quality businesses… An upcoming golden era…

‘Markets are way out of line with reality’…

If you’re a regular Digest reader, that quote from an August 16 Wall Street Journal article should sound familiar.

I (Dan Ferris) have been warning that we’re in a mega bubble for a while. But it’s not often that you see the mainstream media recognizing it. So it’s worth digging into it a little deeper…

The Journal article shows the historical reality of stock market performance and returns compared with valuations measured three different ways.

One is a measure I’ve never seen before: the S&P 500 forward price-to-earnings (P/E) ratio compared with its annualized returns over the next 10 years.

The S&P 500 forward P/E ratio compares the index’s current value with the estimated future earnings of the companies that make up the index. In the past, when this gauge has shown stocks are expensive, S&P 500 returns have tended to be weak over the next decade. And the S&P 500 forward P/E ratio shows stocks are extremely expensive right now.

The Journal also uses the ‘Fed Model’ to show stocks are overvalued…

The Fed Model was created by analyst Ed Yardeni in the late 1990s. It compares the S&P 500 earnings yield and the 10-year Treasury yield. The basic idea is that when stocks’ earnings yields are higher than Treasury yields, stocks are a good buy. When their earnings yields are lower compared with Treasury yields, stocks are unattractive.

Before interest rates fell in July, this measure reached its most expensive level since 2002. But 2002 was the bottom of the dot-com bust. It was one of the best moments to buy stocks in my lifetime. On a split-adjusted basis, Amazon (AMZN) had bottomed out at $0.30 per share in September 2001 and was available for between $0.46 and $1.21 throughout 2002. It’s trading at $172 today – a 576-bagger off the 2001 bottom.

I had to chuckle as I read about the Fed Model. The basic idea of it – comparing stock and bond returns – seems reasonable enough. But any valuation-based measure that tells you stocks were too expensive at one of the great market bottoms in history seems pretty worthless to me.

Which is why I prefer the third valuation measure theJournal cited…

As regular Digest readers know, my favorite long-term stock market valuation tool is the cyclically adjusted price-to-earnings (“CAPE”) ratio. The CAPE ratio today is 34.8, not far below its November 2021 peak of 38.6… which was second only to the dot-com era peak of 44.2 in December 1999.

Whenever the CAPE ratio gets into mega-bubble territory, I pay attention. And it has spent a lot of time there since 2020.

Now let’s add a fourth valuation measure that says stocks have never been more expensive than they are today…

It comes from economist and portfolio manager John Hussman. Hussman’s ratio compares the total market cap of U.S. nonfinancial companies with a measure of their profitability called gross value added (“market cap/GVA”).

Hussman has compared this measure with subsequent 10-year and 12-year returns in the market and found that when market cap/GVA is high, market returns are consistently low. When it peaks, returns go flat or negative for 10 or 12 years.

Market cap/GVA hit its all-time peak on August 23. That’s higher than the previous market cap/GVA peak in 1929. In short, stocks have never been more expensive than they are today based on this ratio.

Now, Hussman knows what people think when he mentions 1929 and its subsequent bear market, when the Dow Jones Industrial Average lost 89% of its value:

I realize that any reference to 1929 is immediately dismissed as preposterous… I think it’s useful to think of that 89% market loss as having two parts. The first initial loss of two-thirds of the market’s value restored historically run-of-the-mill valuations. Policy errors and bank failures then resulted in a loss of two-thirds of what remained. That’s how the market lost 89% of its value (1/3 x 1/3 – 1 = -89%). Presently, I view the first bit as more likely than the second.

I’m less confident than Hussman that we won’t see policy errors and bank failures during the next downturn, though I doubt we’ll see as many as during the Great Depression, when somewhere between one-third and one-half of all U.S. financial institutions failed.

However, I agree with Hussman that today’s peak valuations don’t put a limit on how much speculative excess might occur before it’s all over.

But we still need to warn about these extreme moments. As Hussman says:

Still, there’s a very rare set of market conditions extreme enough to deserve a “warning.” As Madge said in the old Palmolive dish soap commercials, “you’re soaking in it.”

The rarity of big valuation peaks makes it hard to say much about them…

That’s why most folks don’t talk about them. But every investor can easily learn something from them…

The more you pay for an investment, the lower your return will be. That’s simple arithmetic. Think about it this way…

If you buy a $100 10-year bond that pays you $10 a year, that’s a 10% return. If you pay $200 for the same bond, that’s a 5% return. The more you pay, the less you make. In fact, if you pay $200, you’ll make zero, because your total proceeds at the end of 10 years will be $200 – your initial $100 principal and the $100 you earned in interest. Pay more than $200 and you’re signing up to lose money.

Now think of a stock like a bond and a company’s earnings as the rough equivalent of the bond’s interest payments. This is what I have called the “force of gravity”: the relationship between returns and valuation. The more you pay, the less you make. That is your ultimate bottom line as an investor.

No, valuation is not a timing tool…

Frankly, the popular emphasis on timing is a fool’s errand. The best traders I know – and Corey McLaughlin and I have interviewed dozens of them for the Stansberry Investor Hour podcast – don’t time the market. They pursue their own time-tested strategies for entering, exiting, and managing the risk of each position they take. They’re rarely saying, “It’s time to buy this or that investment.” They’re usually saying something like, “The current conditions are likely to produce a profit.”

Even if a good trader talks about timing, they usually mean something slightly different, like the state of one or more moving averages or other specific tools for assessing momentum or sentiment.

Overall, a good trader’s priority is risk management, not timing. They’re mostly focused on avoiding downside. Once they do that, the upside tends to take care of itself.

Too many investors believe there’s some Holy Grail, magic-bullet way to time the market perfectly. There isn’t one, and the longer anyone believes there is, the more money they’ll lose.

In short, it’s not about market timing. It’s about understanding long-term equity returns based on current valuations.

It makes perfect sense that when you pay the most anybody has ever paid for stocks, you’re signing up for the lowest 10-year returns anybody has ever made by buying them.

Mindlessly throwing money at stocks at times like this is like paying $300 for that $100 10-year bond I mentioned earlier. After 10 years, you’ll have $100 in interest you earned, and you’ll get your principal of $100 back, for total end proceeds of $200. If you pay more than $200 for that bond, you’re guaranteed to lose money.

If you think this is a stupid example because nobody buys bonds with negative interest rates, maybe you’re forgetting that there was more than $18 trillion of negative-yielding debt outstanding in the world in early 2020, after the world’s central banks slammed rates down in response to the pandemic lockdowns.

Bonds were more expensive at that moment than they had ever been in 5,000 years of recorded interest-rate history. Some banks that bought bonds at those extremely elevated prices failed in early 2023 after the Federal Reserve raised rates faster than it ever had. Market extremes are dangerous, and that one led directly to three of the four biggest bank failures in U.S. history.

That moment has passed for bonds. There’s no more negative-yielding debt in the world, according to data compiled by Bloomberg. But according to Hussman’s market cap/GVA, stocks are having this type of moment right now.

The idea of talking about stocks as if they were bonds isn’t mine…

I got it from reading Buffettology by Mary Buffett (Warren Buffett’s former daughter-in-law) and David Clark.

Chapter 38 of Buffettology is called “The Equity/Bond with an Expanding Coupon.” You see, where bonds pay fixed interest payments (the “coupon”), stocks have earnings. And earnings can grow – the “expanding coupon.”

Bond issuers have contractual obligations to pay interest. Safe bonds come with high ratings like “AA” or “AAA.” That tells you (most of the time) that the issuer is highly unlikely to default on their obligations to bondholders.

Equity issuers have no such obligation. So Warren Buffett uses his superior investing skills to determine which stocks are most likely to grow their earnings over time. In other words, Buffett looks for companies with earnings growth that he believes is as certain as the contractual obligation of a bond issuer to pay interest.

Finding high-quality businesses with earnings growth is more important than ever today…

In addition to nosebleed stock valuations, short-term interest rates are falling, with the two-year Treasury now yielding around 3.75% – its lowest level since September 2022.

Everybody is in love with the idea of falling rates. But investors tend to buy short-term Treasurys when they’re worried about what’s coming next. That’s why interest rates fall in bad times and during recessions. The Fed cutting rates is a reaction to the bad news it’s getting from the economy.

Nobody I’ve spoken with recently (except Stansberry’s Credit Opportunitieseditor Mike DiBiase) is talking about the high likelihood of a coming recession. But that’s typically what falling interest rates in the wake of a yield-curve inversion have meant.

And we have rising unemployment, most notably in the form of the “Sahm Rule,” which tracks the moving average of unemployment relative to its trailing 12-month low. This indicator has perfectly nailed every recession since 1970. It flashed a recession last month. So technically speaking, we’re already in a recession by this very reliable measure.

But you’d never know any of this by looking at the S&P 500, which is trading just below its July 16 all-time high as I write.

Now, I’m not saying you should sell all your stocks and head for the hills…

Yes, I do believe that the more money you pour into index funds right now, the lower your returns will be over the next several years.

But I would never tell you to sell all your stocks and go to cash. Investing just doesn’t work like that.

Instead, focus on holding an adequately diversified portfolio. For example, in The Ferris Report model portfolio, we hold high-quality businesses like blue-chip, cash-gushing, dividend-paying natural-resources stocks, managed futures, foreign stocks, and precious metals.

That model portfolio is ready for anything. If you can’t say the same about your primary retirement portfolio, maybe it’s time to rethink how you allocate your capital.

Focus on buying great businesses instead of mediocre ones or index funds that mix great businesses with less-than-great ones… at a time when index-fund portfolios have never been more expensive in recorded history.

I also recommend buying alternative investments that will keep your money safe and generate returns while you wait for more attractive valuations to arrive in U.S. stocks.

The good news…

Finding great businesses whose earnings are likely to grow over the long term isn’t nearly as hard as other parts of investing. The hardest part of investing is hanging onto great businesses during downturns.

That’s why I write about the likelihood of a big downturn so often. I don’t want you to sell great businesses. I want you to hang onto them over the long term and compound your money at high rates – just like Buffett has done.

But I also don’t want you to pay way too much for great businesses… which makes it likely that you’ll earn mediocre rates of return for long periods of time.

My good friend – investor and author Chris Mayer – likes to say that now is always the hardest time to invest. That’s true because there’s always some big worry in the market that makes people afraid to leave their money there.

But if you’re doing it right, you’re not buying the whole market. You’re buying great businesses one at a time and holding them for the long term.

So I don’t want you to abandon stocks or stop buying them. But you should temper your expectations about the kind of returns to expect from current levels and focus on long-term returns compared with current valuations.

Now, if the market behaves as I believe it will at some point in the next year – by falling 50% or more – then I’ll likely start singing a much different song, about how wonderful it is to buy stocks trading at attractive prices.

In that case, I’ll use the same $100 10-year bond example from earlier… but I’ll be telling you that you’re getting it for $50 or $60 instead of $200.

In short, don’t be afraid of a difficult market environment ahead. Just keep holding high-quality stocks and bonds. And if the market falls, we could see another golden era of buying great businesses for cheap valuations. At Stansberry Research, we’ll be here to help you through it with our insight, expertise, and advice.

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In today’s mailbag, Digest editor Corey McLaughlin settles an inquiry about our Stansberry Research conference speaker lineup, which he mentioned earlier this week… Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.

“[In Wednesday’s Digest], you listed Billy Beane as being in attendance at the Vegas conference. He passed away a couple months ago… fyi.” – Subscriber Vince B.

Corey McLaughlin comment: Vince, you worried me for a moment, but you’re talking about another Billy Bean (no second “e”) who also worked in pro baseball and played in the majors for three different teams. Bean, indeed, passed away last month from leukemia at age 60.

I can assure you, though, that Billy Beane, the former general manager of the “moneyball” Oakland Athletics who also played for a handful of MLB teams, is still scheduled to present at our conference, which will take place October 21 to 23 at the Aria Resort and Casino in Las Vegas.

We’re looking forward to Beane’s talk next month, along with those of all our special guests, like Moneyball author Michael Lewis and former Secretary of Energy Rick Perry, as well as our crew of Stansberry Research editors and analysts.

About that… don’t forget, as I wrote earlier this week, we’ll be closing in-person ticket sales to our 22nd annual conference soon – on September 18 – so if you are interested in attending, make plans before it’s too late.

You can find more information on tickets, our full event lineup, and accommodations here.

Good investing,

Dan Ferris
Washington, D.C.
September 6, 2024