The stock market reached an all-time high this week, with the S&P 500 index surpassing 2400 for the first time. There isn’t anything in particular about an all-time high that signals an impending stock market crash. Markets achieve new highs all the time. Instead, the relationship between the value and the price of the stock market is the critical factor. When an undervalued market makes new highs, there is no need for concern. However, an overvalued market making new highs is more concerning. Currently, the stock market is not only overvalued but in the midst of a major bubble. This confluence of factors has led me to prepare my portfolio for an impending stock market crash.
The Everything Bubble
Last year, I discussed the warning signs indicating a bubble in the bond markets. That bubble still exists. This is ever more worrying with the existence of a current stock market bubble as well. It is important to carefully consider the difference between a bubble and simple overvaluation in the stock market. One difference is a matter of scale. Overvaluation exists in both an overvalued and a bubble stock market. However, a bubble exhibits much higher levels of overvaluation. Once bubble prices are reached, there usually ceases to be a tangible connection between prices paid and the underlying value of cash flows.
Bubble Warning Signs – Billion Dollar Companies with No Profits
During the Dot Com bubble of the late 1990’s and 2000, many technology stocks were valued at billions of dollars while not producing a profit. This irrational exuberance is an easy example of behavior that occurs in a bubble. Snap Inc had it’s initial public offering this past week and is now valued at $28.36 Billion. Snapchat, the popular social media app, is the primary asset of Snap Inc. Snap is a modern day example of a bubble stock. The company makes no profit and their public disclosure document states that they may never become profitable. For reference here are two relevant quotes from their filing with the SEC:
- “We began commercial operations in 2011 and for all of our history we have experience net losses and negative cash flows from operations.“
- “We have incurred operating losses in the past, expect to incur operating losses in the future, and may never achieve or maintain profitability.”
Snap Inc lost $514.6 million in 2016. All of this money comes out of the pocket of the investors in the company. That’s part of the reason why companies like this go public. They are able to sell shares to the public at overvalued prices and use it to fund continuing operations of the company.
Your goal as an investor is to purchase as much profit as possible for the lowest possible price. Based upon that criterion how much is a company like Snap Inc worth? You want to buy profits, but Snap Inc doesn’t make any profit. Therefore, for an investor who chooses to invest and not speculate, Snap is worth $0. By the company’s own admission, they have only ever lost money and may never become profitable. This one company alone is therefore 28.36 billion dollars overvalued.
Bubble Warning Signs – Billion Dollar Companies with Insignificant Profits
Irrational exuberance can also be evident when profitable companies are valued well above the true value of your current and future cash flows. Netflix is today’s modern example. Last year, Netflix earned $187 million in profit. Based upon the 439 million diluted shares; Netflix earned $0.43 per share in 2016. On Friday, March 3rd, 2017 Netflix traded at $139.14. A simple trailing 12 months price to earnings ratio would be 323. While trailing P/E ratio’s are not sufficient information as a valuation metric, they are useful as shorthand indicators of value. A reasonable valuation is typically a P/E ratio of between ten and twenty. Netflix would have to drop in price by 94% to $8.61 per share to even reach the high end of that valuation range.
Alternative Valuation Metrics – Profits Don’t Matter
It would be reasonable to wonder why investors are willing to pay such an extremely high price for a small stream of profits. As it happens, this is quite a common occurrence during stock market bubbles. Investors begin to use alternative metrics to value potential investments. One of the alternative metrics which has become common during this bubble is the use of revenue growth to justify higher stock prices. Amazon is another example which I previously discussed. Revenue growth without earnings growth is useless for an investor. Only earnings are able to be paid as dividends. Netflix has grown revenue from $4.37 billion in 2013 to $8.83 billion in 2016. This represents an annual revenue growth rate of over 26%. Unfortunately for Netflix investors, the earnings growth rate has been much lower. Earnings per share have only grown at a rate of 12% over that time frame.
A common feature of great businesses is the ability to increase earnings at a faster rate than revenue. This effect is due to leverage inherent in the business as limited fixed expenses are spread out across larger revenues. Netflix does not operate under such a favorable business model. Netflix’s expenses increase proportionally with their revenues because they pay for content each time it’s viewed by their users. Netflix doesn’t have power in the relationship with content providers. Netflix must constantly pay more for it’s content as it’s user base grows.
The market assumes that eventually the quickly growing revenues at Netflix will start to lead to large growing earnings. The market will be wrong in this regard. Investors holding Netflix during a stock market crash, will likely lose a lot of money from current prices. Growth companies with limited earnings are popular during raging bull markets, but drop more during a crash.
Bubble Warning Signs – Stock Index Valuations in excess of National Production
Warren Buffett has spoken a few times about his favorite measure to determine whether the stock market as a whole is overvalued. His preferred measure is the total value of all public companies as a percentage of the entire country’s production. This valuation ratio is known as Market Cap to GNP. This ratio is useful in part because these public companies produce much of the country’s production. If the ratio is high, then the market is valuing each dollar of production much higher than usual. If the ratio is low, then the market is valuing each dollar of production much lower than normal. As things stand today, the Market Cap to GNP ratio is at one of it’s highest levels ever, eclipsed only by the Dot Com bubble peaks in 2000. We are already well in excess of the valuation levels of the 2007 market bubble.
In 2001, Warren Buffett indicated that the Market Cap to GNP ratio should have warned investors about the coming crash during the Dot Com Bubble. If you review the chart of the current ratio, it’s impossible to ignore the similarities between current valuations and past bubbles. You should manage your portfolio accordingly.
Valuations predict future returns – The future is bleak
While it is useful to know that high market valuations are indicative of a bubble, it is much more useful if you can quantify the expected rate of return at current valuations. Dr. John Hussman, an investment portfolio manager, who predicted the stock market crashes of both 2000 and 2007, has done just that. His focus has been on developing correlations between past stock valuations and future expected returns. He agrees with Warren Buffett that Market Cap to GNP correlates well with future returns. However, his preferred measure is non-financial market cap to non-financial gross value added. This ratio provides an even higher correlation to future market returns than Market Cap to GNP. These ratios have continued to have a strong correlation even through the recent Dot Com stock market crash.
Hussman’s current prediction is that current market prices project an S&P 500 total return of less than 1% annually for the next 12 years. With the dividend yield of the S&P 500 approximately 2%, the S&P 500 would be lower than it’s current value 12 years from now. He also projects an intermittent stock market crash of at least 50-60%. This is the crash potential which is now embedded within current stock prices. Are you prepared with your investing plan to prosper amidst a stock market crash of this magnitude?
Stock Market Crash Warnings – The End of Speculation
Stock market bubbles by definition are not rational. They are established through rank speculation which bids prices up to levels without any connection to underlying earnings. However, high valuations alone are insufficient to predict short-term changes in prices. As Benjamin Graham observed many years ago, valuations are only useful as long-term predictors of stock returns. In the short term, stocks can go from overvalued to even more overvalued. This phenomena is necessary for bubbles to develop.
Behavioral psychology is much more useful in predicting short-term outcomes. Greed and fear are common emotions exhibited through the course of the market cycle. As bubbles reach their top, greed is highly present. Speculators extend speculation due to recent success. Their greed fuels motivation to make even more money. As markets bottom, it is the fear in the markets of further losses which lead to investors selling their shares when they shouldn’t. Currently, greed and signs of irrational exuberance are at major highs associated with other market peaks throughout history.
Investing Pendulum – Value vs Momentum
In addition, stock traders tend to follow strategies built upon following momentum. Momentum strategies are quite different from the fundamental analysis strategies which I discuss here at DIY Investing. Instead of focusing on intrinsic qualities of a business, momentum traders use changes in price as their guide. This strategy is usually quite successful through the majority of bull markets and bear markets. Traders will buy when prices have started increasing and sell when they’ve started decreasing. The problem is that the strategy performs poorly during market times of great change. It’s not possible for a momentum trader to predict or prepare for a stock crash, as they only receive their signals based upon past prices. Meanwhile, fundamental analysis clearly shows us that stocks are overvalued at this time.
Value investors are likely to reduce their exposure to stocks as valuations substantially exceed their historical norms. Meanwhile, momentum traders will be going all-in as stocks continue to rise in price. For every stock sold by a seller, there is always an equivalent buyer. Therefore, by definition changes in stock price only occur as one side of the buy/sell arrangement is more enthusiastic than the other. Eventually, there are not enough value investors willing to sell their stocks to the momentum investors. As this happens, most market transactions will take place simply between two traders. This can continue only while a greater fool is willing to take on the risk of market losses.
The actual stock market crash can be triggered by any number of events. It’s pointless to try and predict the actual catalyst. However, the presence of obscene market valuations creates the conditions by which a crash is likely to occur. Catalyst events usually indicate increased uncertainty about the future of market returns. This increased uncertainty reduces the inclination for traders to take risk. As this shift occurs from risk taking to risk mitigation, there is a greater tendency to sell stock holdings. A crash occurs when there is a large enthusiasm to sell stocks, but prices are at a valuation high enough to discourage investors from buying them. Stock market prices then have to drop significantly to reach the point at which value investors are once again willing to accept the risk of the market.
The Coming Stock Market Crash
I have become increasingly concerned with the current valuation levels of stocks. I have backed up my concern with action. Over the past few weeks, I have substantially reduced my exposure to the public stock markets. I’ve liquidated all of my ownership in mutual funds. I’ve also sold off a substantial portion of my ownership position in individual businesses as I work to build up my cash position. Individually, these businesses have increased in price to a large degree over the preceding months, each reaching a point of overvaluation. Currently, I have a portfolio composition of approximately 80% cash and 20% stocks. All of this has been done in an effort to guard against what I view as the increasingly bleak risk/return of stocks.
I am unable to predict the exact timing or magnitude of a stock market crash. This is a feat which I consider impossible for anyone to accomplish. What I am capable of doing, is adjusting the potential risks and rewards of my portfolio to be as favorable as possible. During current market conditions, cash has become a preferred holding over stocks. Stocks represent likely returns of less than 1% annually, with the possibility of large interim losses. Meanwhile, cash represents guaranteed returns of 1% annually without the possibility of large interim losses. Cash also represents the option to make future investments at better prices.
Investors would do well to learn from Warren Buffett’s actions in 2008. He saved up large amounts of cash in the years prior. This allowed him to invest large sums of money in distressed companies as super low prices. You can do the same thing if you are prepared and build up cash in advance. Preparation is only useful when performed in advance of a crash or emergency.
This past week the stock market hit 2400. I predict the S&P 500 index will hit 1500 before it hits 3000.
A stock market crash will come eventually. Based upon current valuations, it would be completely normal for the S&P 500 to decline from 2400 this week to at least 1200 or lower. Drops of 50% are normal to occur in every investing life at least two or three times. Declines of 10% or 33% are even more common.
I encourage each of you to take the time and review your portfolio strategy. If you don’t have a set portfolio strategy, you should consider crafting one. I hope to help you develop the principles and guidelines to successfully manage your own portfolio. For now, remember Warren Buffett’s two rules of investing:
- Never lose money.
- Never forget rule #1.
What are your thoughts on the current stock valuations? How are you preparing for a possible stock market crash? Share your thoughts in the comments below.