“Be Fearful When Others Are Greedy and Greedy When Others Are Fearful”

Major market indexes, including the NASDAQ, DOW Jones Industrial, and the S&P 500, are at, or near, their all-time highs. However, valuation metrics, such as Price-to-Earnings (P/E) ratios, have also risen over the past year, potentially indicating the U.S equity market is overvalued and too expensive. For example, at the writing of this article the S&P 500 currently has a P/E valuation of 25.69, which is over 64% higher than the historical mean of 15.66. This lofty evaluation shows that many investors believe that the current bull market will continue for at least the foreseeable future.  The P/E ratio represents the stock price over the earnings the company has had per share. The higher the ratio the more expensive the stock, higher ratios mean that investors are optimistic that future earnings will be high enough to offset the current valuation. (Tech stocks have high P/E because they’re always expected to earn more down the line). These high valuations indicate that investors are extremely optimistic about S&P 500 companies’ future earnings, and believe that current economic conditions will remain positive.

Reflation trade, nicknamed “Trump trade,” started almost immediately after Trump’s victory last November. Expectations surrounding a lower corporate tax rate and a nascent pro-business economic plan were encouraging to many investors, and an equity run soon began after the initial shockwave of Trump’s victory passed. However, in the months after the election, Trump’s administration has yet to produce any results regarding a new stimulus package or tax rate cut plan. Despite economic ambivalence surrounding the Trump administration, strong first quarter earnings have continued to push the market to record heights.  

S&P 500 Index YTD returns. Taken from CNBC website.

Notwithstanding the success of U.S equities in recent months, until last week, bond prices continued to rise despite the Fed’s plan to raise interest rates multiple times over the next year. While some believe that the surprising success of the Bond market is due to low inflation expectations, I believe that many bond traders are skeptical of the market’s current valuation. The New York Times recently wrote about the exposure cut of U.S equities many global investors made, citing high valuations as a point of caution for many of these investors.

In addition to high valuations, the equity market has experienced a time of near-record low volatility. The VIX, a volatility index, remained at relatively low levels by most historical standards, indicating that the market has been extremely stable during the latest market rally.

Source: Bloomberg, June 2017. VIX Index levels; monthly data January 1990 through May 2017.

I do not believe that this trend will last, and I expect that volatility will pick up during the 2^nd half of 2017. The market has thus far reacted very modestly to political events world-wide, having barely moved despite many of the uncertainty surrounding Washington such as the Russian investigation. This modest-reaction, coupled with a strengthening North Korean missile program, has led me to believe that this low volatility is only temporary and will return to average or even above average levels. Volatility refers to the standard deviation/variance of stock returns over a certain amount of time.

In addition to this low level of volatility, two other major economic trends may signal the end of the reflation trade. Since the beginning of this year, bond yield curves have been flattening. The spread between the two and 30-year Treasury yields fell to a 10-year low of just 137 basis points last week, down from more than 200 basis points towards the end of last year. The spread has rebounded slightly to 153 basis points; however this remains one of the lowest spreads seen in a decade. Yield curves have historically been one of the most accurate predicters of economic conditions and a flattening yield curve potentially indicates weakening economic conditions. According to estimates by Bank of America analysts “Treasury yields either had to rise 50-65 basis points or stocks fall 13-20 per cent to reconcile the differing growth outlooks baked into their prices.” (Financial Times). Not all are worried about the flattening yield curve, some investors believe that declining inflation is a major cause of flattening rates. While a valid argument, I believe that the yield curve flattening is an indicator of weakening economic conditions and should be paid attention to.

Inflated valuations, an expectation of increased volatility, and relatively weak economic metrics including a lowering real GDP growth rate and a flattening yield curve, has caused my view for the 2^nd half of the year to be slightly pessimistic. While I do not expect stocks to drop significantly, I do expect the market growth to slow dramatically, and would not be surprised to see a slight decrease over the next six months.

My view is one shared by many large investment firms, including BlackRock, Goldman Sachs, and JP Morgan. These valuations raise the question; are investors maintaining complete rationality or have they begun to become greedy? I believe the latter, and thus I am fearful that the market may be overvalued. As the famous quote by Warren Buffett goes “Be Fearful When Others Are Greedy and Greedy When Others Are Fearful” -Warren Buffett.

-Thomas Henning