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Is The Stock Market Too Hot?

The markets been on a wild ride this year.

On February 12th, 2020, the DJIA hit its all-time high of 29,551.42.

This after an 11+ year 128 month streak of going straight up. The longest bull market in US history.

The US and worlds economy were running smoothly. And nothing looked like it was going to stop this continued rise.

Then the coronavirus left China and began its rapid spread worldwide.

In mid-March, the DJIA crashed from its all-time high on February 12th to 18,591.93 on March 23rd, 2020. Or a fall of 37.1% in a little over a month.

Then in April, May, and Early June 2020 the DJIA recovered as it rose back to 27,572.44 on June 8th, 2020. Or a rise from its March lows of 46.4% in about a month and a half.

This was the best 50-day period in the DJIA’s history.

And then this past Thursday June 11th the market fell by 1,861.82 points or 6.9%.

We haven’t seen the market react like this since The Great Depression.

This is all well known since the daily market news is everywhere on TV and online.

But what isn’t talked about during this craziness are the fundamentals.

The founder and creator of value investing has a wonderful saying that illustrates this perfectly…

“In the short, the market is a voting machine. But in the long run it’s a weighing machine.”

Meaning, in the short run markets are based mostly on emotion, momentum, and the news cycle. While in the long-term markets run on fundamentals.

So what do the fundamentals of the market tell us today?

One way to measure this is with ratios… What I’m going to show you today is what’s called the Shiller PE Ratio.

This is different from the normal P/E ratio. This is price divided by earnings AKA net income. Earnings are also known as profits.

What you’re trying to see here is the price of the stock divided by the profits it produces to see if you can buy the company at what is called a “fair” or undervalued price.

This varies by investor, but many investors want to buy at a P/E ratio below 15 or 20. Because many investors see this as the fair value range of a stock.

The Shiller P/E Ratio or Cyclically Adjusted PE Ratio (CAPE) uses the same two metrics in its calculation but it also adjusts for inflation and is mainly used to gauge the value of the entire market not individual stocks.

This ratio allows you to see a “truer” view of the market of time since inflation is taken out of the equation.

And today’s CAPE ratio is 28.5. Or far above what most investors are willing to buy at.

Let me put this into some context for you…

The only other times in history this metric has been higher going back to the late 1800’s was during the early 2000’s Dot-Com boom and right before The Great Depression.

That’s it.

The average CAPE during this 120+ year period is 16.7.

Meaning that as of today, the market is 41.4% overvalued when compared to the historical average.

Plus on top of this the economy is doing much worse and tens of millions in the US are unemployed.

In other words, the market is about the same valuation as it was in March – pre Covid – when it had a CAPE near 33. But the entire economy is in much worse shape today and the fundamentals aren’t as good as they were then.

Doesn’t make much sense.

This is why you see the likes of Mark Cuban and other prominent investors saying we’re likely headed for another major market crash soon. Because based on the historical average CAPE we are and current economic fundamentals we are.

Now does this mean the market is going to crash today, tomorrow, or even any time soon? No.

Markets can stay irrational for long periods of time… As the legendary economic John Maynard Keynes said “the market can stay irrational longer than you can stay solvent.”

What this does mean though is a few things.

a. You should reassess the investments in your portfolio to make sure you’re still comfortable owning them for the long term.

b. If you’re looking to buy new stocks now you need to be careful.

No this doesn’t mean sell your entire stock portfolio. And no this doesn’t mean you can’t find great stocks still today that will make you money over time.

What it does mean is that you need to be cautious.

Because the market is far likelier to fall by 50% than it is to rise by another 50% due to its historically high valuations.

As always, we’ll keep you updated on anything we see on this front.

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