Stock Market Overpriced by 50%?

As the key stock indices approach highs not seen since just before the financial crisis, the underlying fundamentals are screaming “watch out.” The stock market could be edging higher on nothing but false optimism and greed.
 

The most basic reason for any stock market rally, corporate earnings, is missing from the equation. The bellwether stocks are flashing warning signals. Just as one example, United Parcel Service, Inc (NYSE/UPS) reported lower-than-expected corporate earnings for the fourth quarter of 2012. For the first quarter of 2013, the company expects to earn less than originally anticipated. (Source: Associated Press, January 31, 2013.)

Looking at corporate earnings expectations from a broader viewpoint, they are declining as the key stock indices inch higher. The corporate earnings growth rate for S&P 500 companies in the first quarter of this year was forecast at 5.1% in September of 2012. In December, the forecast declined to a corporate earnings growth of 2.4%. Now, according to FactSet, the corporate earnings growth rate for the first quarter of 2013 stands at -0.04%. (Source: FactSet, February 15, 2013.)

As I have documented in these pages, companies on key stock indices are showing better corporate earnings by cutting costs and buying back shares, as opposed to increasing revenues. In the fourth quarter of 2012, employee compensation (wages) only accounted for 54.7% of U.S. gross domestic product (GDP)—the lowest level since 1955. (Source: Wall Street Journal, February 11, 2013.)

Key stock indices are becoming significantly overpriced. The value of the U.S. stock market stands at about 133% of GDP. The average for the past 60 years has been around 82%. By this measure, the U.S. stock market is overvalued by more than 50%!

With all this, the question still remains, where are key stock indices headed next? I’m in the camp that believes that heavy corporate insider selling, declining corporate earnings, severe economic problems in Europe, and too much bullishness and a slowing economy in the U.S. will limit the upside potential for stocks. In fact, I think a major top is being put in place for the market.

While the mainstream focuses on the price-to-earnings (P/E) ratios of companies on the key stock indices, I am more focused on the demand side and the ability of corporate America to earn money in the future. The truth is that the fundamental reasons for this stock market rally are deteriorating daily. Time will certainly tell us more, but remaining cautious seems to be a good option for investors right now.

Michael’s Personal Notes:

The Congressional Budget Office (CBO) expects the U.S. federal government to have a lower budget deficit this year than those of the previous four years—finally getting the annual deficit under $1.0 trillion (although, not by much). But I am skeptical when it comes to the CBO estimates, as financial conditions at the more local level paint anything but a rosy picture.

Our country has already faced one credit rating downgrade and chances are another one is in the making. Why? Cities across the U.S. are in deep trouble, as their massive deficits continue to increase.

Take Detroit, for example. The city is on the verge of bankruptcy again due to the severe downturn in the local economy and the city’s annual deficit. Detroit’s residents are fleeing the city, with the population down 30% since 1990. (Source: Reuters, January 28, 2013.)

Troubles in California persist. Multiple cities in the state have already filed for bankruptcy; others may also follow suit. Fresno, the fifth-largest city in the state, is in financial stress. Fresno’s credit rating has already been downgraded by Moody’s. The credit rating agency notes that the city already has a high deficit, high payrolls, and other fixed costs in the background of a deteriorating economy. (Source: The Sacramento Bee, February 11, 2013.)

Sadly, this doesn’t just end here. Moody’s downgraded 11 municipalities in the U.S. from stable to negative—and all these cities had a credit rating of “AAA” prior to the downgrade. (Source: Barron’s, February 6, 2013.)

It would be good to finally see the federal government get its annual deficit under $1.0 trillion, but issues with cities are going to increase the U.S. debt. How? As cities run deeper deficits and are unable to pay for their expenses, they will need help. Municipalities will eventually run toward the state governments for a bailout, and the states will seek help from the federal government for more money. Once states require more money, the federal government will see its annual deficit increase, and the U.S. debt will become a bigger issue.

Dear reader, as American cities continue to post deeper deficits and get their credit ratings cut, the outcomes will be harsh on municipal bonds. Keep in mind, a deeper deficit means more borrowing. Until the cities get in better financial shape (which could take until the end of this decade), the U.S. national debt rising substantially higher than predicted remains a real risk.

What He Said:

“There is no mixed signal about this: Foreclosures in the U.S. will continue to rise, the real estate market will get weaker, and the U.S. economy will get weaker. Smart investors should seriously consider unloading their stocks of consumer-products companies that produce nonessential goods.” Michael Lombardi in Profit Confidential, March 12, 2007. According to the Dow Jones Retail Index, retail stocks fell 42% from the spring of 2007 through November 2008.