Stock Market Valuations Are About To Get Real

On today’s show we are talking about stock market valuations and how Wall Street justifies these high valuations.

A year ago the Dow Jones Industrial average was trading at an average of 18.17 x earnings. Value investors the world over were fretting about how such a high valuation could be justified. As of Friday, the Dow was trading at 22.56 x earnings.

First of all, let’s unpack what that means. The Price To Earnings Multiple is a measure of how expensive an investment is.

In absolute terms it means that you would have to hold a stock on the Dow for 22.5 years for a company to earn back the investment an investor has made in the company.

Let’s look at a low growth company like Consolidated Edison which provides regulated electricity, gas and steam to customers primarily in the NY area. Because they’re in a regulated industry, their ability to grow is limited by the utilities commission setting the rates that can be charged. Revenue grew by 0.1% last quarter. In the past year, Con Ed saw their net earnings shrink by 10.9%. Well Con Ed is trading today at 22 x earnings. This is a stock that should trade at a lower multiple. Historically, low growth stocks like this have traded at lower multiples like 10-12 times earnings. They’re stable year over year.

I predict that we’re going to see a return to fundamentals in the near future. This is going to start with the more aggressively priced companies and then will spill over to the broader market. Today we still have a situation where the majority of trades in the market are computer program trades and not actual legitimate investor activity.

We also have a large percentage of the investor market now investing in ETF’s, funds that track the market indexes.

Let’s look at a stock like Apple or Google. These have traditionally been considered high growth stocks.

We’ve been dealing with the Corona Virus outbreak for more than a month and the markets have shrugged it off and pushed valuations to all-time highs. Clearly investors have been disconnected from what is happening on the ground.

We now have Apple issuing guidance that their first quarter will be impacted by supply chain issues. As of Monday’s opening bell, the shares were down 8% for the week and down 6.6% over the weekend.

It doesn’t make sense that Apple trades at a premium to the market. The market multiples for Con Ed don’t make sense either.

I’ve talked about 2 companies at opposite ends of the business spectrum. I believe that my argument applies to all the companies that occupy the space between these two companies.

I believe that we will see a precipitous drop in the market averages as analysts come to grips with the true impact of the Corona Virus outbreak on the global economy.

So far in the past week, we’ve seen a 4% drop in the S&P 500.

Many have pointed to the stock market shrugging off the concerns about Corona Virus as a reason not to worry. Let me remind you of the irrational exuberance of the .com bubble in the late 1990’s. I lived through those days in the tech sector and was part of a company that had just gone public in the run-up to the .com crash.

Markets have a way of being very wise in hindsight, but not so forward looking.

Whether in good times or bad, but overwhelmingly when valuations are historically high I believe it is prudent to take a more defensive posture and invest in hard assets. Apple lost nearly 8% of its value in a few short days. Hard assets don’t typically exhibit that kind of volatility.