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Executive Summary

There is real excitement in the market as the S&P 500 Index approaches its February all-time high.  So, in this week’s newsletter I am going to take a look under the hood to see if all the hoopla is warranted.  First, for the first six months of 2020, S&P 500 GAAP earnings are down 61% compared to the same period in 2019.  Using Warren Buffett’s favorite valuation metric, price-to-GDP, the first chart below illustrates the record overvaluation.  A further glance under the hood uncovers a problem with market breadth.  The following five mega-cap stocks:  Apple, Amazon, Facebook, Google and Microsoft are the objects of much of the excitement and speculation.  The second graph below shows that these five stocks are skewing the picture which is not shared by the remaining 495 companies in the Index.  It looks like the excitement may also need to be construed as red flags of elevated risk.  A 61% drop in earnings is not good.

Please proceed to The Details for the complete explanation.

“Regret is unnecessary. Think before you act.”
–William Shockley

The Details

The excitement is real as the S&P 500 Index approaches its February all-time high.  The Fed is doing all it can to keep the market rising with the help of speculators, many of whom have never experienced a full bear market cycle.  So, let’s open the hood on the S&P 500 Index and see if all of the hoopla is warranted.

Investors negotiate stock prices based upon expected future cash flows.  Once prices exceed such levels, those purchasing stocks become speculators hoping other speculators will keep purchasing, thereby forcing prices higher.  Then, as with all speculative cycles, something – an unexpected exogenous event (such as COVID-19) or simply the disappearance of speculators willing to purchase at existing prices – initiates a sell-off eliminating the speculative excesses.  This is sometimes called a reversion to the mean; however, often the market drops to valuation levels below the mean.

For the first six-months of 2020, net (GAAP) earnings for the S&P 500 are down 61% compared to the same period last year.  At the same time, the price of the S&P 500 is 11% higher this year than it was on June 30, 2019.  Make sense?  You might want to look at those numbers one more time.  The speculators, with the Fed’s help, have done an outstanding job creating the largest disconnect from fundamentals in history.  Using Warren Buffett’s favorite valuation metric, price-to-GDP, the chart below illustrates the record overvaluation.

Since the S&P 500 is a market-cap weighted index, the largest companies (those with the highest market-cap – total shares outstanding times the market price) represent the greatest portion of the index.  A healthy market is one where prices are reasonable based upon earnings and when the gains are spread out and not confined to a handful of the largest companies.  Unfortunately, this market meets neither of those conditions.  As shown above, prices are massively overstated relative to earnings, and most of the stock price gains have come from speculators purchasing the five largest companies.  These mega-cap stocks include:  Apple, Amazon, Facebook, Google and Microsoft.  Economist Lance Roberts of Real Investment Advice calculated that these five companies represent the same portion of the S&P 500 Index as the total of the bottom 394 stocks.

Chart 1

In fact, only about 55% of stocks in the S&P 500 are trading above their 200-day moving average.  This is an indication of weak breadth in the market.

posts chart 2

To highlight the absurdity, over the past year Apple stock has risen 126%.  Their revenue, on the other hand, has only increased by 7%.  This is called a disconnect.

Some speculators are hanging their hat on hopes the economy will bounce back, and corporate earnings will return to prior levels.  Unfortunately, the way the pandemic is playing out and the amount of debt being incurred to merely “get by” will prevent this type of quick recovery.  See the graph of total debt to GDP below.

posts chart 2

Analysts are always quick to raise and slow to downgrade forward earnings expectations.  But, even if S&P 500 earnings for the final two quarters rise as much as hoped-for, as shown on the S&P Dow Jones Indices website, then the full year’s net earnings for 2020 would be down 38% compared to 2019.  And, the full-year 2020 hoped-for earnings-per-share of $87 would be the same as that seen in 2016, and again prior to that in 2012.

The speculation has reached a level where the Put-Call Ratio, or a ratio of those purchasing put options versus call options on the S&P 500, is near a record low.  This implies that on a relative basis more investors are betting on further market increases instead of hedging against a downturn.  Notice in the graph below, previous similar incidents occurred before large market corrections.

Simple logic indicates that a 61% plunge in earnings should correspond to a reduction in the price of the things that generate those earnings.  The fact the stock market, which was hugely overvalued before the pandemic, is again approaching all-time highs, simultaneously with one of the worst decreases in earnings ever, should be a major warning flag.

A 61% drop in earnings is not good and should not be rewarded with even more overvalued prices.  Near-retirees should take note of what a prolonged bear market could do to one’s retirement expectations.  If one is waiting for a signal that caution should be warranted, there are more than enough around – if one were to take the time to observe them.  The disconnect has never been greater.  In the short-run further gains are possible but holding too long could result in major regret.

The S&P 500 Index closed at 3,271 up 2.4% for the week.  The yield on the 10-year Treasury Note rose to 0.56%.  Oil prices increased to $41 per barrel, and the national average price of gasoline according to AAA remained at $2.18 per gallon.


© 2020. This material was prepared by Bob Cremerius, CPA/PFS, of Prudent Financial, and does not necessarily represent the views of other presenting parties, nor their affiliates. This information should not be construed as investment, tax or legal advice. Past performance is not indicative of future performance. An index is unmanaged and one cannot invest directly in an index. Actual results, performance or achievements may differ materially from those expressed or implied. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy.

Securities offered through First Heartland Capital, Inc., Member FINRA & SIPC. | Advisory Services offered through First Heartland Consultants, Inc. Prudent Financial is not affiliated with First Heartland Capital, Inc.