Fears are growing that the U.S. stock market is in dangerous territory.
The chart below illustrates the return on each of the three major stock indices since the 2008 Financial Crisis.
As you can see, the Nasdaq Composite, up more than 243% since 2009, is leading the way higher. But lest you think the run-up is reminiscent of the tech bubble of 1999, both the S&P 500 and Dow Jones are also gunning higher -- up more than 157% and 142% respectively.
All three indices are solidly at record high levels.
Now, such a chart would normally be interpreted as bullish -- and rightly so. But we're not in normal times. Currently, the S&P 500 is trading at 25.8 times earnings (on a GAAP basis) and at almost 30 times by the cyclically-adjusted price-to-earnings ratio (CAPE). That's a whopping 78% higher than the historic CAPE average of 16.7.
In fact, there is really only one widely used financial metric that isn't screaming about stock market valuations: The price to free cash flow ratio (P/FCF), which is trading at roughly 25 -- a relatively small 12% discount to the historic average of 28.4.
So, it's no secret that the stock market is overvalued. But that isn't unexpected.
You see, thanks to the Federal Reserve's easy money policy, we're in the ninth consecutive year of stock market gains. And such a long winning streak virtually guarantees above-average valuations on almost every financial metric.
Can Prices Go Higher?
This is the question on everyone's mind. And given the actions of the Fed since the Financial Crisis, there are legitimate reasons for arguing that U.S. stocks can go higher in the face of these high multiples. Leading the way are the historically low interest rates, even with three rate hikes by the Fed in the past 18 months or so.
At the time of this writing, the 10-year Treasury trades at $1021.25 and yields 2.14%. That's a price earnings (P/E) ratio of about 48. In other words, it would take nearly half a century for an investor to recover the bond's purchase price through coupon payments. By the way, that P/E ratio is higher than the CAPE ratio at the height of the tech-bubble in 1999.
Now, it's clear to everyone that the reason bond yields are so low is that the Fed has artificially pushed interest rates lower. They lowered banks' funding costs to near zero, while also buying government and mortgage bonds on a massive scale. This forced bond prices higher and yields lower.
Unfortunately, the Fed's recent rate increases have not affected long-term yields. Long-term interest rates are the average of the expected trend in short-term rates over the maturity of the bond. So, even if short-term rates go up, long-term yields can remain unchanged (or even decline) for an extended period.
Because Wall Street expects the Fed to keep rates at artificially low levels for the foreseeable future, stock prices can continue to rise despite abnormally high valuations on market metrics. So, in many ways, stock market valuations just aren't that important while the Fed is goosing the market.
When Should Investors Get Worried?
There are no easy solutions when investing in an overvalued market because every strategy has flaws. So the trick is to stay bullish until the alarm bells start ringing loudly that the Fed's economic intervention is failing.
How will investors know?
So long as Wall Street continues believing that short-term rates will stay at artificially low levels, yields on the 10-Year Note will continue to trend within a relatively narrow range. But, as the Fed raises short-term rates, they risk inverting the bond yield --a situation where short-term rates yield more than long-term rates.
Should this occur, equity markets will fall.
Considering the Fed expects to raise rates another 50 basis points in 2017, short-term rates could go to 1.5% by years' end. Now, as long as the 10-Year stays above this level, investors will be relatively safe.
But if Trump's tax and spending plans are thwarted by Congress, the 10-Year Treasury yield could fall to levels last seen in 2015. This will precipitate a recession.
And here's the kicker…
A recession with valuations so out of whack from historic averages would be severe -- severe to the point of catastrophic. Even worse, with the Fed's bloated balance sheet and already low interest rates, the Fed has little ammunition to stem the downtrend.
Now, the yield curve has predicted the last seven recessions going back to 1961. It's a pretty safe bet that it will predict the next one too. And it's the one indicator investors should keep their eye on.
Until then, the bulls will prevail.
Risks To Consider: So long as the market continues with an expectation of tax cuts and infrastructure spending, the yield curve is unlikely to invert. But exogenous risks exist that could cause rates to invert independent of Trump's plans, such as armed conflict with North Korea or another major geopolitical event.
Action To Take: As the spread between long yields and short yields narrows, investors need to plan and implement their exit strategies.
Editor's Note: Everyone knows that Social Security is in bad shape. But most people don't realize just how desperate the situation is... to fix Social Security benefits have to be cut by 22% immediately. Or payroll taxes have to jump by 32%. So you're facing pain whether you're working OR retired. But there's a way out. A program that can pay you $43,543 per year for the rest of your life. And it has nothing to do with the government. Check it out here.