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How to Get Rich Investing in Stocks by Riding the Electron Wave

Stock Markets Are Riding High on Thin Air

Stock-Markets / Stock Markets 2015 Mar 01, 2015 - 06:13 PM GMT

By: Money_Morning


I am often asked by the investors in my funds, "When will markets finally start paying attention to the signs of weak economic growth?" I tell them that the consensus answer is that bull markets only end when the Fed starts aggressively raising interest rates.

I also tell them that when interest rates are at zero, as they have been for the last seven years, the normal answer may not apply. In the meantime, stocks keep hitting new record highs while bonds and commodities are telling a very different story about the state of the economy…

Low Yields Have Grounded Any Flight to Safety

In February, the S&P 500 enjoyed its best performance since October 2011 despite the worst economic data in over a year. With the exception of employment-related numbers – which are both backward-looking and overstated – economic reports were nothing short of horrible. Even the labor markets are far from healthy at U6, the broadest measure of unemployment, remains above 11%. But virtually every measure of manufacturing, construction and consumer activity was extremely disappointing and came in below expectations in February.

So why do stocks keep going up? The most common answer given by experts is that equities remain the only game in town for investors. The Fed and other central banks have destroyed bonds as alternatives by lowering interest rates to zero.

Only a masochist (or a central bank or private sector bank investing for non-economic reasons) would lend money to governments for 10 years or longer at rates of 2% of less. And corporate bonds are hardly more attractive, with the yield-to-worst on the Barclays Investment Grade Bond Index at a paltry 2.87% and the yield-to-worst on the Barclays High Yield Bond Index at a measly 5.91%. Yields on BB bonds are 4.48%, B-rated bond yields at 6.03% and CCC-rated bond yields are 9.24%. Take it from a bond market veteran – these yields come nowhere close to rewarding investors for the risks of holding these instruments in any environment, but in a world drowning in debt, they are nothing more than certificates of confiscation.

Comparing This Market to the Internet Bubble is Rationalizing

There are other reasons why stocks keep going up. One reason is that there are few sellers among large institutions precisely because they have nowhere else to put their money because bonds are so unattractive. Another reason is that the consensus (which is nothing more than a dignified word for groupthink) has convinced itself that stocks are not expensive.  The way the consensus reaches this conclusion is by comparing today's stock valuations to the most ridiculously overvalued stock market in history – the Internet Bubble.

Take Barron's Randall Forsyth, who writes in the March 2, 2015 issue of that publication:  "The crazy valuations seen at the turn of the millennium – when silly concepts, such as collecting eyeballs and sock puppets hawking pet food, attracted billions of dollars from breathless speculators wanting to get in on the new, new thing – are absent. So, the Nasdaq trades at a reasonably sane 21 times forward earnings, a far cry from the triple-digit price/earnings ratio commanded at its March 2000 peak, and not far from the current 17.5 P/E of the Standard & Poor's 500."

But this is tantamount to arguing that a 5'6" man who weighs 500 lbs. and then loses 100 lbs. is no longer obese. It is a badly flawed argument that is nothing more than a ticket to the investment boneyard.

Mr. Forsyth's argument, which is representative of the bull market case, is deficient from the following respects. First, a 17.5 forward P/E on the S&P 500 is not a cheap valuation; it is an expensive valuation. It is inflated by phony accounting for stock option compensation, massive debt buybacks that are much larger than they were in the Internet Bubble, low interest rates and other factors.

Further, other ways of measuring the P/E ratio also show an expensive market. The Shiller Cyclically Adjusted P/E Ratio, which measures P/Es over a 10-year rolling period, is currently 27x versus a mean of 16.6x.

And P/E ratios are only one way of measuring valuation, and not necessarily the most useful. Other measures, which are equally if not more valid, show also show that today's market is extremely expensive. One such indicator is the price to sales ratio, which currently stands at 1.7x, below the Internet Bubble level of 2.1x but well above the 2007 level of 1.5x. Unlike earnings, companies can't phony-up sales with fancy accounting tricks, which is why many market pros look to this measure for guidance. And it looks like year-over-year sales for the S&P 500 may drop in 2015 for the first time since the financial crisis.

Another measure of stock market value, Tobin's Q Ratio, which weighs the value of the S&P 500 divided by the net worth of the assets on corporate balance sheets, is at its second highest level in history at 1.09x (it was at a preposterous 1.6x during the Internet Bubble).

Finally, the S&P Market Cap/GDP Ratio, which Warren Buffet told Fortune magazine "is probably the best single measure of where valuations stand in any given moment," stands at 1.27 compared to a mean of 0.65. At almost two times its mean, this ratio is screaming overvaluation.

So while the market may not be as bloated as it was during the Internet Bubble, it is still bloated. And ignoring the danger signs of excess can be very dangerous to your health – and that is exactly what investors are doing.

The Apple Effect on Markets

There is another phenomenon that is warping the market:  the Apple Effect. With a market capitalization of $750 billion, Apple, Inc. (Nasdaq: AAPL) is by far the largest company in the history of the stock market. It represents 10% of the Nasdaq Composite Index. But it is something more – it is a cultural and media phenomenon. In that role, it exercises an enormous psychological effect on the market that allows it to drag the entire Nasdaq with it when its stock rises. Part of this effect is real – the Apple ecosystem includes a lot of other companies that profit from Apple's success. But part of this effect is unquantifiable because of Apple's huge presence in the media.

Unlike any other company in the history of the stock market, Apple possesses enormous mind share in the financial, media and technology worlds and emits a force field that is almost impossible to measure. Apple stock has risen by 70% over the last 12 months and by 16% year-to-date and is exercising an enormous gravitational pull on the overall market, not just the Nasdaq. We have never seen a company as large as Apple, as cool as Apple, and grow revenues and profits at the highest rate in the history of business. While Apple is still rising, it may be very difficult for the market to go down. But it is going to be an enormous challenge for Apple to maintain its growth rate at its current size. If the Apple effect fades, the market could pay a big price.

The Numbers and the Takeaway

For the moment, however, there are few signs that stocks will retreat in the near future. Last week, the Dow Jones Industrial Average paused from its incessant rally, dropping 7 points or close at 18,132.70 while the S&P 500 shed 0.3% or 6 points to end the week at 2104.50.

The Nasdaq Composite Index added 8 points in its desperate attempt to reclaim its Internet Bubble peak, finishing at 4963.53. Stock markets outside the U.S. fared much better with the MSCI World Index gaining 1% for the week and enjoying a 5% year-to-date.

Of course, these gains are due primarily to excitement over currency gains in Europe and Japan rather than to any great economic news abroad.

But investors will take what they can get; they are rewarded for making money, not for endorsing wise economic policies.

Source :

Money Morning/The Money Map Report

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