Mitch on the Markets

July 19th, 2021

Do High Valuations Signal a Bear Market Ahead?

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The 2000 tech bubble may be responsible for a myth in stock market investing. Here’s the myth: high valuations (P/E ratios) give way to long and steep bear markets. It seems like a logical idea and takeaway, but history doesn’t support it. 

When the market crashed in 2000, many dot coms were trading at outrageous P/E ratios, and the S&P 500 was expensive – trading at a 25.2x forward P/E. Every reader remembers the bear market that followed.

In recent years especially, I see quite a few comparisons of the current market’s valuation to its valuation in the late 1990s, and some prognosticators seem to imply that the higher the stock market’s valuation goes, the closer we may be to a big and long bear market. But examining history shows that high valuations do not necessarily lead to high magnitude and long duration bear markets. In fact, the opposite is true.1

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Even if we enter a big and long bear market, the key is to prepare your investments for the long term. Don’t let fear and emotions urge you to time the market and make short-term decisions. Instead, we recommend looking into key economic indicators that can make a positive impact on your financial success.

To help you do this, I am offering all readers our just-released Stock Market Outlook report. This report contains some of our key forecasts to consider such as:

If you have $500,000 or more to invest and want to learn more about these forecasts, click on the link below to get your free report today! 

IT’S FREE. Download the Just-Released August 2021 Stock Market Outlook2

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In a recent study that looked at all bear markets since 1900, it was found that there is little correlation between CAPE (cyclically adjusted P/E) ratios and the size/scope of bear markets. Some of the biggest bear markets in history started when CAPE ratios were relatively low, and some of the smallest and shortest bear markets started when valuations were elevated. For all the bear markets examined from 1900 onward, more than 50% of them were longer when their valuations were lower than the long-term average P/E at the outset.

One specific example was the fierce bear market that went from September 1939 to April 1942. The U.S. economy was battered from the Depression, and World War II was an existential threat to the nation. But when the bear market started, stocks were largely undervalued – the CAPE ratio was sitting at 16.45. Many factors triggered the bear market, but expensive stocks weren’t one of them.

Investors are constantly searching for ways to ‘value’ the market. Valuations help us determine when stocks are cheap and therefore attractive, or when they’re expensive and should be avoided. But valuations alone should not direct an investment strategy. There are too many other factors to consider: interest rates, inflation, earnings growth, geopolitical forces, technological innovation, and so on down the line.

Looking at valuations in a vacuum will not give an investor the full picture of the economy and stock market, in my view. I have also written before about a weakness I see in the CAPE ratio as a valuation tool. Investors should note that the CAPE ratio uses decade-old earnings data, which is great for historical comparisons but tells us virtually nothing about what lies ahead (which is exactly what we need to know to inform investment decisions).

Factors like cheap energy, falling commodities prices, productivity gains, currency fluctuations, and new technology (to name just a few) can contribute significantly – or conversely weigh down – a company’s future earnings. A stock’s price today is greatly influenced by what investors are willing to pay for expected earnings, meaning that sentiment and growth forecasts play key roles. The CAPE ratio doesn’t account for either. If they did, and you relied on the CAPE metric as a proxy for when to invest in the last twenty years, you may have never owned equities! For a long-term growth investor, that would have been a mistake.

Bottom Line for Investors

If today we saw a confluence of negative economic data alongside a high and rising CAPE ratio or other valuation measures, then we’d probably have something to fear. But I don’t see this.

The forward P/E on the S&P 500 is currently around 21x, which is probably lower than most investors would have guessed and should be looked at relative to longer duration U.S. Treasury bond yields (which remain low historically). We also have S&P 500 companies turning in record earnings and raising estimates for future quarters – S&P 500 earnings per share (EPS) estimates for 2021 have jumped from $167 at the beginning of the year to $191 six months later.

In my estimation, the global economy is set for more expansion ahead, not the opposite. And I believe stock prices should do what they’ve almost always done ahead of further economic expansion – go up. And that’s even if the P/E of the market is above 20x.

Whether stock prices rise or decline, we still recommend that investors stay prepared for any given situation. In such early stages of recovery, one way to stay prepared is to stay focused on the facts and key data points that can positively impact your long-term investments.

To help you do this, I am offering all readers our just-released August Stock Market Outlook Report. This report contains some of our key forecasts to consider such as:

If you have $500,000 or more to invest and want to learn more about these forecasts, click on the link below to get your free report today!

Disclosure

1 Wall Street Journal. July 5, 2021. https://www.wsj.com/articles/how-long-might-the-next-bear-market-last-11625499653?mod=djemMoneyBeat_us

2 Zacks Investment Management reserves the right to amend the terms or rescind the free Stock Market Outlook offer at any time and for any reason at its discretion.

3 Zacks Investment Management reserves the right to amend the terms or rescind the free Stock Market Outlook offer at any time and for any reason at its discretion.

DISCLOSURE

Past performance is no guarantee of future results. Inherent in any investment is the potential for loss.

Zacks Investment Management, Inc. is a wholly-owned subsidiary of Zacks Investment Research. Zacks Investment Management is an independent Registered Investment Advisory firm and acts as an investment manager for individuals and institutions. Zacks Investment Research is a provider of earnings data and other financial data to institutions and to individuals.

This material is being provided for informational purposes only and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. Do not act or rely upon the information and advice given in this publication without seeking the services of competent and professional legal, tax, or accounting counsel. Publication and distribution of this article is not intended to create, and the information contained herein does not constitute, an attorney-client relationship. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were or will be profitable. All information is current as of the date of herein and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole.

Any projections, targets, or estimates in this report are forward looking statements and are based on the firm’s research, analysis, and assumptions. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and suitability specifications. All expressions of opinions are subject to change without notice. Clients should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed in this presentation.

Certain economic and market information contained herein has been obtained from published sources prepared by other parties. Zacks Investment Management does not assume any responsibility for the accuracy or completeness of such information. Further, no third party has assumed responsibility for independently verifying the information contained herein and accordingly no such persons make any representations with respect to the accuracy, completeness or reasonableness of the information provided herein. Unless otherwise indicated, market analysis and conclusions are based upon opinions or assumptions that Zacks Investment Management considers to be reasonable. Any investment inherently involves a high degree of risk, beyond any specific risks discussed herein.

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