"If you're in the market, you have to know there's going to be declines."
- Peter Lynch
Since 1950, the S&P 500 index, which tracks the performance of 500 large public companies in the United States, has been fairly valued or undervalued for most of the 70 years. These valuations allow for steady returns and a reliable market with minimal levels of volatility.
However, there have been two instances in these 70 years where the S&P 500 has been extremely overvalued – the dot-com bubble in the late 90's and right now. This is not to say that the market is going to react in a similar manner to the crash of the dot-com bubble. Still, it is safe to say that the current market, as a whole, is overvalued.
These high market valuations can be seen in the two graphs above, both of which are concerning. The price-to-earnings ratio, or PE ratio, divides a stock’s share price by its earnings per share. It shows relative valuation through the multiple of earnings that the market is willing to pay for a share of stock.
The first graph shows the S&P 500’s PE ratio since 1950 compared to its average. As previously referenced, the present and the dot-com bubble are two times over this period where the market has been overvalued by two standard deviations of the PE ratio. The current market is well beyond the dotted line, representing the average PE since 1950. In the dot-com bubble, the S&P 500 fell by almost 50%, showing investors need to be wary of valuations nearing previous highs.
In the second graph, the Shiller PE ratio is used. This form of the ratio is similar to the original, but it is averaged out over ten years and adjusted to inflation for more accuracy. Here it can be seen across the 150 years shown by the graph that the market is at its second-highest valuation, only behind that of the dot-com bubble. Any time this ratio has been above a value of 30, there has been a severe market crash – eg. Great Depression and the dot-com crash. The market currently sits at a SchillerPE of 34.81; if history repeats itself as it tends to, investors should brace themselves for rough market conditions. Low-interest rates enable the market to stay at these valuations without crashing, but if they end up rising, it could be detrimental.
From the recent years of near-zero interest rates, low bond yields, and a large influx of federal spending into the hands of investors, it can be seen why the stock market has seen such an attractive investment. The historical returns realized over this period have also caused many to oversee the current burdens on the market. Intense inflationary pressures, record gas prices, the aftermath of a brutal pandemic, 20-year highs in S&P 500 valuations, and the conflict between Russia and Ukraine are all weighing down investor sentiment.
Domestically, the most significant concern today is inflation, which can ruin a country’s economy if not properly contained. The Fed has already announced its plans to implement a contractionary monetary policy, which reduces the money supply through increased interest rates. With inflation surging, there is no alternative to the Fed raising rates, which has the possibility of sparking a surge of selling in equity markets.
Rising rates are unattractive to businesses because it increases the price of borrowing money, leading to higher costs for companies to finance their operations. These costs usually result in lower profits due to the added borrowing expenses. Moreover, most companies use a large amount of debt in their capital structure to finance their business and invest in growth. Therefore, a hike in interest rates affects almost every public and private company by increasing its borrowing costs. The repercussions typically lead to a slowdown in overall economic growth.
Considering the current overvaluations in the stock market, which signals that investors expect a large amount of growth in the coming years, a rise in interest rates could serve as a negative catalyst for stocks. Higher rates prompt people to invest in new bonds and to hold more money in savings accounts, driving capital away from overvalued stocks. Although, during a time of rising rates, the bond market also can hurt investors, dependent upon which bonds they invest in. Similarly, there will still be an opportunity to profit in equity markets, but the stellar returns seen by most companies from mid-2020 until late 2021 should not be widely expected.
The current market environment is comparable to an overinflated bike tire. The tire, representing the stock market with high valuations, can still be used, but it will not be as smooth of a ride as with a perfectly inflated tire. Some air must come out of the tire to sustainably function. Similarly, money leaving the stock market brings companies back to fair valuations. No different from how air from the tire doesn’t just disappear; it goes back into the environment into the air we breathe; the money from the equity market gets invested into bonds, savings accounts, and other lower-risk investments.
Alternatively, this is a healthy stock market if rates stay where they are. However, nobody knows where rates are going, and it is difficult to predict the stock market’s performance. With the current pace of inflation and the Fed’s sentiment, rates will likely rise. The amount by which they rise will make or break the overall markets, but it will be hard to stop the surging inflation and please equity investors simultaneously.
In these times, being a blind investor in indices may lead to the inability to produce returns for years. During the dot-com bubble, which is the last time S&P 500 valuations were as high as they are now, it took eight years for the market to achieve its previous highs again.
That said, even in this new bubble, there is an abundance of possibilities for investment profit in the markets. The next newsletter will detail how to mitigate risk and safely navigate an overvalued stock market.
Siddharth Singhai
Chairman & CIO of Ironhold Capital
Disclaimer:
This White Paper expresses the views of the author as of the date indicated and such views are subject to change without notice. Ironhold Capital has no duty or obligation to update the information contained herein. Further, Ironhold makes no representation, and it should not be assumed that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This White Paper is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Ironhold Capital Fund 1, L.P. (“Ironhold”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based
