A Time For Caution In Today’s Overvalued Market
The U.S. stock market is on track for one of its best years ever, with the S&P 500 up 28% for 2024.
One big problem: the future earnings outlook is trending in the opposite direction.
The consensus analyst estimates for next year’s S&P 500 earnings peaked in July, and have been trending downward. As of today, analysts have increased their expected earnings for next year by just 1% compared with a 28% gain in stock prices. This means that virtually all of the gains in the S&P 500 this year have not come from expectations of higher future earnings growth, but rather from investors paying more for the same amount of earnings.
Based on the current consensus among Wall Street analysts, who are calling for $272 in earnings per share (“EPS”) for the S&P 500 next year, the index trades at a 22x forward price-to-earnings ratio. That’s right at the valuation level where the market peaked in November 2021, and just 12% below the 25x forward multiple reached at the height of the dot-com bubble.
Seeing stalling earnings and rising valuations, corporate insiders are cashing out in a big way.
The ratio of insider selling to buying has reached six to one, or double the average of the last three years, and the highest level in over two decades. When this ratio has reached such extreme levels in the past, it has provided an early-warning indicator of market turbulence (including when it reached a high of 5x in late 2021, just before the 2022 bear market).
While corporate insiders and Wall Street analysts wave the caution flag, retail investors have never been more euphoric, measured by the Conference Board’s Consumer Sentiment Survey. The latest data from November’s survey revealed that 56.4% of consumers expect higher stock prices in the year ahead – setting a new record high for the second time this year.
Signs of retail investor enthusiasm include the record percentage of household net worth currently invested in the stock market. Even more concerning, retail investors are piling into the most speculative corners of the market. Consider the case of leveraged exchange traded funds (ETFs). Leveraged ETFs are funds that use borrowed money to give investors exposure to 2x or 3x the daily returns of individual stocks. Meaning if a stock goes up by 3% these leverage funds will increase by 6% or 9%… Of course, the same leveraged moves occur on the downside as well.
The amount of investor dollars pouring into leveraged ETFs reached a record $120 billion in November. That’s up 100% in the last two years, and 50% above the levels reached at the prior peak in the market in Q4 2021.
Rarely has this level of investor optimism, leverage, and speculation run so rampant at a time when valuations were so high. And it never ends well.
While our message is not new to regular readers, we believe it bears repeating: we continue to urge extreme caution in today’s market.
This doesn’t mean sell everything and stuff your cash in the mattress. But it does mean maintaining a comfortable cash position, and preparing for the possibility of a sharp and prolonged downturn in financial markets (for more details on how to raise cash, see our recent issue dedicated to the topic, here).
This includes bracing for potential downside even among some of the names that have performed well in the Big Secret portfolio so far this year. In this update, we’re reviewing the latest developments of a few of these outperformers. We’ll also cover several stocks that have experienced declines despite strength in their underlying businesses, and which we believe offer an attractive risk/reward opportunity.
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