Cast your mind back to the days in March when stocks were in freefall and everything around you, from the NBA to weekend plans, was suddenly postponed indefinitely.
At the time, it might have been hard to believe that the market would be back at all-time highs by the summer. And yet, investors had cause to celebrate last month as the S&P 500 confirmed three new closing highs.
The rally’s unusual speed was not lost on anyone — not Wall Street strategists who scrambled to upgrade their year-end price forecasts, or young day-traders who rushed into trading. For Doug Ramsey, chief investment officer of The Leuthold Group, the “present-day market mania” is reminiscent of the dot-com era in ways that indicate the sell-off earlier this year is to be continued.
His flashbacks are not merely occuring because technology stocks are all the rage again — although that’s an important factor. He is also flagging that investors have once again imbibed a narrative of unrelenting gains.
In the late 1990s, investors were obsessed with tech companies that were ‘obvious’ beneficiaries of the internet boom.
These days, the bulletproof narrative is not that certain tech companies will continue outperforming. It is that the Federal Reserve and Treasury will continue intervening to keep businesses afloat — including those with distressing balance sheets that would otherwise terminate them.
This narrative implies that confidence in supportive policies and so-called free money now trump concerns about excessive valuations.
“In some ways we think the psychology is even more dangerous than 20 years ago,” Ramsey said in a recent note.
He reflected on the dot-com era market action to show what happens when valuation returns to the forefront of investors’ minds.
Using the stock market as a forward-looking indicator of the economy, Ramsey noted that investors are usually comfortable with calling the bottom in stocks once it’s clear that an expansion is in place. They are right for the most part, and the bull markets continue until the next recession comes around.
But there are a few exceptions where stocks dipped again even after the coast was clear. They include the collapse in 2002 that sent the market below its September 2001 nadir even though the recession was over.
“We think this is relevant because the 2020 decline exhibits a strong resemblance to the ‘incomplete’ bear market of March 2000 – September 2001 — in that neither decline sufficiently deflated the extreme valuations of the preceding bull, and each was followed by an immediate rebound in reliable valuation measures to top decile levels.”
To wit, the S&P 500 normalized price-to-earnings ratio briefly fell below its September 2001 low during this year’s crash. But the tech-led rebound has swiftly returned it to 29.1 times, a level higher than 98% of all the historic data.
“In an incredibly short time, the market has discounted not only the end of a recession but a return to ‘the greatest economy of all time’,” Ramsey said. “We expect Large Caps to reset to significantly lower valuations at some point in the year ahead— and that’s not predicated on a ‘double dip’ recession.”
He went a step further to compute the stock market’s potential upside and downside if investors reconsider the valuations they assigned during the swift rally.
His analysis included five median valuation metrics for the S&P 500: trailing P/E, normalized P/E, price to cash flow, price to sales, and price to book. In an extreme scenario where stocks keep rallying and these metrics rise to match their highest month-end readings since January 1990, the median stock would gain 10% from here.
However, in the opposite extreme situation where these metrics revert to their lowest month-end readings in 30 years, the median stock has 64% downside, Ramsey concluded.
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