As the world begins to emerge out of their homes and back into the crowds of the marketplace, a familiar feeling of normalcy seems near. However, the rubble left behind from a global pandemic is not yet completely in our past. With unemployment rates still higher than pre-COVID levels, and many small businesses continuing to struggle, it would seem reasonable to expect that the market has not yet returned to the same strength as it was before the pandemic. However, that is not the case; the stock market experienced a record-fast recovery and is now at historical highs. As Michael Arone, Chief Investment Strategist at State Street Global Advisors put it, “... investors continue to scratch their heads wondering why the stock market could perform so strongly while the economy, labor market and earnings face such challenges."
Although it is possible to disregard this discrepancy and assume this to be part of the natural ups and downs of the market, that may not address how historical highs were so closely followed by historical lows. The Schiller PE ratio, which calculates the price per earnings of the S&P market for the past 10 years, and is a relatively good indicator if the market is overvalued, currently stands at 37.8, compared to a historical average of 16.5. This means investors are willing to pay a 130% premium to own shares in the S&P 500.
Historically, there are only two other times that the Schiller PE ratio has reached this level: in the months leading up to the Great Depression and right before the fall of the dot-com bubble. The Wilshire 5000 GDP ratio, which compares the total U.S. stock market value with the U.S. GDP, currently stands at 1.9 in comparison to the historical mean average of .83. In today’s economy, this large discrepancy between the market evaluation with the actual gross revenue can be a red flag.
There are two major factors that may be the impetus for the over-evaluation of today’s stock market. In order to combat the economic distress of recent times, the U.S. government kept interest rates low so that Americans could borrow more money, spend it in the market and stimulate the economy. To make money more accessible and keep these rates low, central banks have been printing more money. The production of money, and the subsequent spending occurring in the market inflates prices. With interest rates low, Americans are incentivized to move their money from their low-yielding bank accounts into more lucrative investments, such as real estate and the stock market, which has contributed to the upward trend of asset inflation.
The second contribution to the rise in the market is the ongoing influx of new investors and a frenzy of speculation. With easier access to investing in the market and the newfound popularity of “trendy stocks,” many uneducated investors are simply hopping on for the ride. As Chief Investment Strategist, Jeremy Grantham said, “there is nothing more supremely irritating than watching your neighbor get rich.” The Bitcoin and GameStop craze are both prime examples of this attitude. In the age of social media it has never been easier to see your friends triple-digit percentage gains on a trending stock. The desire to buy in as well, only contributes to the inflation of prices that are not necessarily backed by value. This cyclical nature of buying is threatening to the market.
Regarding periods of speculation, Charlie Munger, the vice-chairman of Berkshire Hathaway, commented, “well these things do happen in a market economy. You get crazy booms ... My policy has always been to just ride them out ... [Many] buy stocks on frenzy because they see that they're going up, and that’s a very dangerous way to invest.” Whether or not a crash is ensuing, it’s important to keep in mind that value-based investments will always prevail in the long run and patience is your best friend.
Photo Caption: As the wellspring of the market continues to thrive many economists maintain that investors are destined to discover only a mirage.
Photo Credit: Pixabay