On May 12, the professional tea leaf readers at Goldman Sachs Research predicted the S&P 500 would increase by about 11 percent to 6,500 over the next 12 months. We’re one month into the forecast, and the S&P 500 has increased from 5,844 to 6,045 – or by about 3.4 percent.
Goldman’s optimism was based on reduced U.S.-China tariff anxieties, and better than expected economic growth forecasts. The bank’s economists put the chance of a U.S. recession at just 35 percent over the coming 12 months, with GDP expected to expand by 1.6 percent.
The big question David Kostin, chief equity strategist at Goldman, wants answered is “who is going to pay the increased tariffs?”
Will Chinese producers eat the costs? Will Walmart take it out of its already razor thin profit margins? Will consumers get stuck with higher prices?
These questions will not be answered for another quarter or more. First quarter earnings showed a healthy 12 percent year-over-year growth. But this was before the trade war kicked in. Second quarter results are when we’ll likely start seeing impacts from reduced demand and diminished profit margins.
There’s also the possibility that trade discussions with China fail to reach an agreement. What will this mean for Goldman’s 12-month forecast?
The S&P 500 could certainly continue to rise in the face of a deteriorating economy. We all know that Wall Street – and President Trump – is eager for a rate cut.
Maybe bad news for the economy, like slow growth and rising unemployment, will compel the Federal Reserve to cut rates. This, in turn, will be considered good news for stocks by the masses of investors who always want a reason to buy.
A New Bull Market is Born?
The Wall Street cheerleaders have reason to celebrate. The S&P 500 recently closed 20 percent above its April 8 low. This means a new bull market has officially been born. The tariff tantrum fears of early April have disappeared like mist in the morning sun.
The CNN Fear & Greed Index is now firmly pointing to greed. A “greed” reading means that investors are showing high levels of optimism and a willingness to take on more risk. This also means that buying pressure is strong, and investors are willing to push stock prices higher.
Moreover, the American Association for Individual Investors (AAII) survey is in the process of turning bullish. The percentage of bears has dropped to 33.6 percent as of June 11th. Although this is still above the historical average of 31.0 percent, it is a significant retreat from the elevated 61.9 percent we witnessed in early April. Retail investors, it seems, are being lured back into the meat grinder.
From our perspective, this isn’t a genuine recovery. Clearly, it’s not being driven by strong economic fundamentals. In fact, it’s not a new bull market at all. It’s the same old bull market that’s rising on a tide of ever-increasing debt.
The prospect of Fed rate cuts is adding more fuel to the fire. President Trump is aggressively lobbying Fed Chair Jerome Powell to cut interest rates by a full percentage. He wants Rocket Fuel!
Powell has resisted Trump’s demands and name calling so far. But he’ll eventually bend. All it will take is a negative economic data report he can point to for justification. Then Trump will get his way…though he may not get the result he expects.
What Your Broker Won’t Tell You
Rising stock prices in the face of deteriorating economic fundamentals is the best kind of bull market. It rewards mindless risk takers and punishes prudent pragmatism. The risks, however, should be appreciated.
The popular financial services industry wants you to believe the party in the stock market can go on forever. They point to headlines, to quarterly earnings, to the momentum of the S&P 500.
At the same time, they ignore the real underlying market fundamentals. Those who pause to consider actual market valuation quickly realize the rising S&P 500 Index is built on a foundation of sand.
A look at the Cyclically Adjusted Price-to-Earnings Ratio (CAPE) offers a perspective you won’t likely hear from your broker.
The regular Price-to-Earnings (P/E) ratio is simple enough. It tells how much you pay for a dollar of a company’s earnings. But the problem with the straight P/E ratio is earnings can be volatile. One good quarter, one bad year, and the P/E becomes distorted. That’s why Robert Shiller came up with the CAPE ratio.
Instead of just using the latest year’s earnings, the CAPE ratio takes the current price of the S&P 500 and divides it by the average of the past ten years of inflation-adjusted earnings. This smooths out the volatility and provides a clearer picture of whether stocks are genuinely cheap or expensive.
What does this key metric tell us today?
At market close on June 12, the S&P 500’s CAPE ratio was 37.05. As perspective, the historical average CAPE ratio for the S&P 500 since 1881 is 17.24.
The CAPE Crusader Unveils a Bubble
When you see a CAPE of 37.05, you’re looking at a market that is more than twice as expensive as its long-term average. This isn’t a slight overpricing. Rather, it’s an extreme overvaluation. This is, in fact, a bubble.
Historically, whenever the CAPE ratio has been this elevated, the subsequent 10-year returns for investors have been terrible – often negative in real (inflation-adjusted) terms.
To be clear, the CAPE ratio is not an explicit market timing tool. Valuations over the coming months could always become more extreme. However, the CAPE does provide insight into future long-term returns. Right now, it’s signaling that you’re paying a premium for an asset that is unlikely to deliver satisfactory returns for years, if not decades.
Over the next few months, the prospect of Fed rate cuts could further inflate the bubble. Lower borrowing costs, as a product of central bank manipulation, tend to fuel speculation. This could push the S&P 500 Index higher in the short term. By then, any potential reward would be completely overwhelmed by the underlying risk.
The current CAPE ratio is approaching the dot-com bubble of the late 1990s, when it peaked at 44.19 in December 1999. It’s well above the peak of 31.48 that was hit just before the 1929 crash. Both of those episodes ended in tears.
So, as the S&P 500 makes a run at a new all-time high over the coming days, the CAPE crusader’s warning is clear. Investors are currently paying ridiculous bubble prices for earnings.
Caveat emptor.
[Editor’s note: Trump Sends Strange “Coded” Message to Conservatives (Liberals Can’t Figure It Out!). Democrats are complaining that Trump is doing something illegal… but conservatives understand EXACTLY what he’s telling them to do. Click here to see what we see next for Trump’s “Master Plan”.]
