Investor optimism and market valuation are at an extreme level
Investors have seen stock prices rise sharply since their March 2020 lows, but there is enough reason to believe that the rally will last too long and the risk of a significant decline is substantial.
The rally has generated significant investor complacency, which in the past has typically been preceded by market declines. Evidence of the dangerous level of current investor optimism is presented in a series of charts. Examples are also given of the extreme levels of market valuation that this optimism creates.
But first a cautionary story that stock markets don’t always go up. Investors can lose money for many years buying at market highs.
One of the many psychological pitfalls that lead to investor complacency as we see it in today’s markets is known as freshness bias. There is a tendency to believe that recent events can be projected into the future.
In times of generally rising markets, investor complacency is encouraged by instilling the belief that buy-and-hold and buy-the-dip strategies can be safely implemented.
Part of the appeal of these strategies is that they are intellectually undemanding and require little thought about current market conditions or prospects.
There are plenty of examples. The graph above shows that investors who bought near the 1929 high had to wait until the early 1950s to break even. More recently, buyers of the Nasdaq near the internet bubble peak waited about 20 years to break even. Buyers of tulip bulbs during the 17th century tulip mania would still be underwater today!
History has taught that the best time to buy stocks is when the consensus view is negative and the best time to sell when everyone is optimistic. Investors have seldom been more optimistic, as the following graphs show.
The graph above shows that the enthusiasm for stock market investments is extreme. The money invested in stocks in the past 6 months exceeds the total for the past 12 years!
An old investment maxim is that bull markets don’t end with the general public, otherwise known as “retail investors,” who come into the market on a large scale. This type of behavior was seen before all major market spikes, including the turn of the century internet bubble and the 1929 market crash.
Lately, not only have there been a lot of new investors, but they are also taking out large loans to get even more involved in the market. The recent surge in margin debt growth is the strongest in over 25 years, even beating pre-Internet bubble peak in 2000, providing additional evidence of the speculative mania that has gripped equity markets.
The chart shows a worrying trend that the strongest spikes in margin debt growth precede significant market declines. We are in such a situation today.
The number of initial public offerings of stocks is a useful measure of investor sentiment. Bullish investors tend to have a keen appetite for new stocks that investment bankers are happy to raise
The most reliable IPO-related leading indicator for market direction is derived from observing the amplitude of change (rising or falling), with significant changes in IPO activity tending to precede the opposite behavior in stock market indices.
IPO activity is currently showing a dramatic increase in activity, which supports our thesis over the past few months that the markets are currently an unattractive risk / reward proposition.
The cover of the December 4, 2020 issue of the major UK financial publication MoneyWeek (see below) suggests that the next decade will be a boom time for investors. Other publications have promoted the Roaring 20s theme.
The use of front pages to measure investor sentiment has been used for decades. They have often proven to be a useful counter-indicator. The best-known example is BusinessWeek’s 1979 cover story “The Death of Equities,” which preceded the largest bull market in history.
Common companions of rallies driven by overly optimistic investor assumptions are high-priced markets that pose their own risks to the inadvertent.
The following two graphs suggest that current stock markets are among the most expensive in history.
Value for money is a useful measure for evaluation because the outcome (the ultimate determination of business value) is a direct result of sales. High price-to-sales ratios increase the likelihood that future sales and / or profits will not meet expectations and increase the risk of a sharp decline in stock prices.
The current price-performance ratio slightly exceeds the high values reached at the height of the internet bubble.
The Buffett indicator compares total equity to GDP. An important observation from the chart below is that stocks are currently severely overvalued, surpassing the previous high during the internet bubble era.
A second is that the current level of overvaluation is only predicted 2% of the time, but it has occurred twice in the last 20 years! Extreme events occur in markets more often than the probability predicts due to human psychology, which tends to create bubbles and crashes. For example, probability theory would not have predicted that there would be three major stock market crashes between 1987 and 2008.
The current combination of heightened investor sentiment and market valuation makes buying new equity positions a risky undertaking.
Those who already have positions in the stock market should develop a plan to receive capital in the event of a market downturn.
The expected volatility in the stock markets will bring both great risks and opportunities. The best odds will come when most investors are bearish. The greatest risks come in times of extreme uptrend, as is the case today.