Why Lofty Valuations Are Okay

11 mins read
Why Lofty Valuations Are Okay

Another big name sounds the alarm on stock market valuations … why it doesn’t mean a huge crash is imminent … how Louis Navellier and Matt McCall are seeing 2021

 

Based on our [stock market] valuation work, we are anywhere from 20% to 30% overvalued based on a whole bunch of different metrics.

So says investor David Rosenberg. He served as Merrill Lynch’s top North American economist from 2002 to 2009.

To be fair, though Rosenberg is a smart guy, he’s known for his pessimistic views.

For example, back in January 2019, he went on record calling for a recession that year. He puts the odds at 80%, based on the Fed’s tightening policy at the time. As we all know, no such recession occurred.

Now, what’s most interesting about Rosenberg’s comments today is that despite his valuation-concerns, he isn’t calling for a stock market crash.

Why exactly?

Well, here too, he points toward the Fed — this time to the zero-rate environment it’s created.

From Rosenberg:

What’s holding the boot together is basically zero interest rates.

As long as rates remain where they are, unless we have a real dramatic pullback in economic activity, this bubble that we’re in is probably not going to burst any time soon.

 

***Regular Digest readers know we don’t disagree with Rosenberg on any of this

 

By traditional metrics, stock valuations are, in fact, highly stretched.

Take the price-to-earnings (PE) ratio.

This is perhaps the most frequently referenced valuation metric used by investors. It measures how much investors are paying today relative for recent earnings.

Below is a chart of the S&P 500’s PE ratio dating back to 1870.

As you can see, valuations have only been higher during two periods — the Dot Com collapse, and the Global Financial Crisis.

 

 

As I write, the PE ratio sits at nearly 37.5. For context, its long-term average is a shade under 16.

That puts today’s PE ratio more than 130% higher than average levels.

Now, markets tend to mean-revert over time. And typically, the further “stretched” a market valuation grows, the more likely it is to revert … and the faster and more dramatic those reversions often are.

It’s similar to a rubber band — the more you pull it to its elastic limits, the greater the pressure grows for it to return to “normal.”

Given how stretched today’s market is, this dynamic doesn’t bode well for investors.

But …

As Rosenberg noted, we have to factor in what the Fed has been up to.

 

***Zero-interest rates change the stock valuation picture

 

Stocks are expensive according to the PE ratio.

I think we can all agree on that.

But let’s step back and add some perspective around this statement.

What a PE ratio doesn’t tell us is what’s happening in the broader economy and investment markets. It makes no allowance for varying economic realities.

As an analogy, say you have a man who stands 6′ 3″.

Is that tall?

Compared to most men, yes. The average height for men is about 5′ 7′.

But what if he’s hanging out with a bunch of professional basketball players, who average 6′ 5″?

Relative to them, he stands slightly under average height.

PEs don’t give us this type of relative information. But in the world of investments, we find that market leaders, ratios, and metrics are always changing relative to one another. Any sort of “absolute truth” that remains constant, year-in-year-out, is hard to come by.

Given this, we have to allow room for PEs to be just part of the story. So, we need to factor in another critical part of this story …

Interest rates that are pegged at zero, courtesy of the Fed.

So, what’s the effect on markets?

Well, in a zero-interest-rate environment, fixed income investments tend to yield close to nothing.

This forces a great many income investors into stocks in an effort to get a return that beats inflation. This naturally inflates the market’s valuation.

So, a PE ratio of 37 when rates are at 0% is very different than when rates are at, say, 3.5%.

Now, this doesn’t mean that stocks aren’t expensive. They are. But it does mean that current expensive valuations have greater justification — and have greater staying power as long as the Fed maintains its current zero-interest-rate policy.

On that note, this past Monday, Chicago Fed President Charles Evans gave investors a reason to believe this policy will be in place for the foreseeable future.

From MarketWatch:

In a speech at the annual meeting of the American Economics Association, Evans argued that Fed officials shouldn’t settle for just getting inflation slightly above 2% …

“To me, getting inflation moving up with momentum and delivering rates around 2.5% is important for achieving on our inflation objective in as timely a manner as possible,” he said …

It likely will take years to get average inflation up to 2%, which means monetary policy will be accommodative for a long time, Evans said.

“This translates into low-for-long policy rates and indicates the Fed likely will be continuing our current asset purchase program for a while as well,” Evans said.

In other words, market valuations can remain higher than normal, for longer than normal.

 

***This is, in part, why our own Louis Navellier and Matt McCall are incredibly bullish on stocks in 2021

 

For newer Digest readers, Louis and Matt are two of our most respected analysts, despite having very different approaches to the market.

Louis is a classic “bottom up” investor.

He has objective criteria programmed into highly advanced computer models that signal what to buy, when to buy it, and when to sell to collect the profits.

After finding investment candidates, he evaluates their broader sector to make sure he still likes the overall opportunity.

Matt is a classic “top down” investor. He starts by analyzing entire sectors and trends poised for huge growth like autonomous vehicles, 5G, or Artificial Intelligence.

After identifying an attractive one, he then digs deeper to find the specific stocks best positioned to capitalize on that broad sector trend.

Despite these differences, one thing they’re in complete agreement on is the opportunity for wealth-building in 2021.

That’s why they came together last month to create a best-of-breed portfolio, called the Power Portfolio 2021. It’s a collection of hand-selected stocks that pass Louis’ and Matt’s strict selection-criteria.

But that’s just the first step.

After making Louis’ and Matt’s respective short-list, the potential stocks are then evaluated through the lens of 2021’s anticipated market conditions — such as the extended zero-interest-rate environment we just discussed.

The result is a small basket of elite stocks, tailor-made to outperform over the next 12 months. This is the second year Louis and Matt have offered this service. And same as last year, the Power Portfolio 2021 comes with a guarantee — if its return doesn’t 3X the return of the Dow Jones this year, then subscribers will get the following year’s Power Portfolio for free.

(Last year’s Power Portfolio easily made good on the guarantee, posting a return that was about 6X the Dow’s performance.)

Matt and Louis will be shutting the doors to this service in the coming days, but there’s still time to get in now.

In fact, they’re adding another stock to this portfolio todayClick here for more.

Wrapping up, yes, Rosenberg is right — stocks are expensive. But when we factor in interest rates, it paints a different picture. It creates the conditions where certain, elite stocks can generate huge returns in 2021. That’s exactly what Louis and Matt did last year and what they’re aiming for in 2021.

On that note, I’ll let give Louis the final word:

Matt and I don’t want you to do “average” this year, we want you to bring in extraordinary returns.

So, the Power Portfolio 2021 is our exclusive guide for positioning your portfolio to take advantage of all this year will have to offer investors.

If you’re interested in being a part of this exciting wealth-building journey, please click here.

Have a good evening,

Jeff Remsburg