Stocks are near record highs, with the market trading at levels last reached during the 1999-2000 tech bubble and just before the historic 1929 crash. And yet investors seem unconcerned.
The market has rarely been this expensive. A measure known as the CAPE Shiller P/E ratio – which looks at stock prices divided by adjusted earnings over 10 years — is around 33. That is nearly double the historical average.
It’s a tad pricier than the 1929 ratio of 27, just before the Great Depression era, according to research from Jim Reid, a strategist at Deutsche Bank.
Reid is worried that this means stocks are due for a major pullback. He’s not alone.
“Mean reversion is like gravity. You can only resist it for so long,” said Todd Lowenstein, equity strategy executive of The Private Bank at Union Bank, in an interview with CNN Business. “Valuations eventually will come back into vogue. They still matter.”
But what if this time is different?
Some experts argue that stocks can trade at such lofty levels for extended periods of time, especially since interest rates are so low and are likely to remain near zero for several more years. And the current P/E ratio is still below the peak of near 50 during the dot-com boom.
What’s more, investors seem more than willing to forgive, or even ignore, high prices and valuations for companies that consistently post strong earnings and sales growth. Just look at Amazon, which has never been a bargain stock since going public in 1997.
Expensive tech stocks have lived up to the hype
Amazon (AMZN) trades at a nosebleed valuation of 70 times expected 2021 earnings. But that hasn’t deterred investors, including old-school value fans — probably because analysts expect Amazon (AMZN) to post annual earnings gains of more than 35% for the next few years.
Even Warren Buffett’s Berkshire Hathaway (BRKB) owns a small stake in Amazon.
“There definitely been a lot of momentum in the market, but that is indicative of what is expected in the future,” said Charlie Ripley, senior investment strategist with Allianz Investment Management, in an interview with CNN Business.
“Valuations are in focus in the tech sector but the pandemic has accelerated some trends, and at the end of the day, these companies are generating strong earnings,” Ripley added.
Deutsche Bank’s Reid conceded in his report that “it can take a lifetime of investing and structural shifts” for valuations to move back to historical norms. In other words, expensive stocks can stay at frothy levels for years — even decades.
As long as big tech companies, which dominate the major indexes, continue to report solid earnings gains, stocks may still rise higher.
In short, two acronyms sum up the current market mentality: FOMO, the fear of missing out, as investors sitting on the sidelines realize that stocks are going up in a so-called TINA trading frenzy. TINA stands for There Is No Alternative to the US stock market.
“There is still a lot money on the sidelines waiting to get in,” said Chad Oviatt, director of investment management with Huntington Private Bank. “And while some individual stocks are overbought, the whole market isn’t.”
Oviatt told CNN Business that investors may be underestimating the extent to which earnings will bounce back in 2021, saying that current forecasts for about a 20% increase might be too low and that profits could climb more than 25% next year.
What goes up must eventually come down?
Still, Oviatt recognizes that the market is not cheap. Conservative investors should look for dividend-paying companies, he added, since many investors starving for consistent income won’t find much in low-yielding bonds.
But a reckoning could be coming for pricey growth stocks.
“I’m troubled by high valuations,” said John Lynch, chief investment officer with Comerica Asset Management. “I would love to say that the recent gains are justified, but growth may not be as good as investors expect in the first quarter of 2021.”
Lynch worries that investors are underestimating the possibility that the market will finally cool off next year.
He has a current target price of 3,875 for the S&P 500 in 2021. That’s up 5% from current levels – a respectable but hardly gangbusters gain. Lynch told CNN Business that earnings will have to grow a lot more dramatically for stocks to justify their current prices.
Union Bank’s Lowenstein added that investors are ignoring many risks that could push down market valuations. He said the Fed could finally start hinting that rate hikes are coming down the road as the economy stabilizes. That could send shock waves through the market.
This year’s strong stock gains may also be a sign that investors are already pricing in that the worst could be over next year on the pandemic front, he said. So 2021 gains may simply have been pulled forward to now.
In other words, next year could be the inverse of 2020. Wall Street might suffer even as Main Street consumers finally start to do and feel better.
“The market is following the path of expected vaccine success while the economy is following the path of the virus and shutdowns,” Lowenstein said.
“There is a chasm between financial assets and the real economy,” he added. “The economy may do better than stocks in 2021 because the return to normalcy is priced in.”
