Is the stock market risky now?

The S&P 500 market index is up 96% since its crash in March 2019 and it has delivered the sharpest recovery that the index has known. Within a little more than a year’s time, it’s already 34% higher than its levels before the pandemic when companies were doing business as usual.

Many investors made money due to the stock market crash last year but the economic landscape has changed. Nowadays we are navigating through a stock market landscape that is breaking record after record. This leads to joy and enthusiasm among investors, but also to uneasiness for some prominent figures on Wall Street. As the stock market is already running higher than before the pandemic, is it time for a market correction?

To answer this question, we need to analyse an abundance of elements of the (stock) market. I have analysed and compiled a selection of indicators that are worth looking out for. The indicators range from market-specific valuation metrics and macroeconomic indicators to the behaviour of companies and the sentiment of investors.

1. Market Valuation

S&P 500 PE Ratio
The price-to-earnings ratio shows how much money a company earns compared to its stock price. The average PE ratio for the companies in the S&P500 is currently 35.34. This means that the companies in this index, on average and at their current performance, need to work more than 35 years to repay their share price.

To put this in perspective, we can look at PE ratios over the last 150 years. Before the global financial crisis in 2008, the PE ratio shot up to 67. Our current PE ratio is lower than the last crisis. And looking at the graph, it is also lower than the PE ratio before the dot.com bubble burst in 2000 where the PE ratio was 44 before the stock market went down.

Remind that the current PE ratio of 35.34 is only an average which does not mean that all companies are currently overvalued. The notion of a healthy PE ratio depends per industry and even per company as, for example, growth companies justify a higher-than-average PE ratio if they have future potential and have shown strong historical growth.

Although, for me as an investor, the current market valuation is on the high end for my taste. Looking at the graph it seems every sharp increase of the PE ratio either follows a descent or is an omen for a downturn.


Shiller PE Ratio
Also known as CAPE, the cyclically adjusted price-to-earnings ratio is calculated by dividing the current price of the S&P500 market by its average inflation-adjusted earnings over the last 10 years.

The graph below shows that we are currently on 39.06, which is lower than the value prior to the dot.com bubble, but higher than the CAPE of 27.5 before the financial crisis of 2008.

This ratio is used to gauge whether the market is overvalued by comparing its current market price to its inflation-adjusted historical earnings. The CAPE provides a better picture of the market’s sustainable earning power by using average earnings over a decade. While CAPE is not intended as an indicator of market crashes, a high CAPE is associated with such events.


Buffett Indicator
The Buffett Indicator compares the Wilshire 5000 Total Market Index (roughly taken the total United States stock market valuation) to the GDP. In August 2021, the aggregate US market value is 54.8 trillion dollars. Dividing this by the annual GDP of 23 trillion dollars leads to 238%, which suggests that we are in a strongly overvalued market.

Also, the global version of the Buffett Indicator reached a record high of 142% last week. This indicates that stocks, in general, are overvalued and could face a downturn in the near future.

The Buffett Indicator represents expected future returns relative to current performance, as the stock market value represents expectations of future economic activity and the GDP measures actual economic output. Some studies have shown a strong correlation between US GDP growth and US corporate profit growth. And when stock prices get too far ahead of corporate profits, this isn’t a good sign for the stock market.

2. Macroeconomic Indicators

Inflation and interest rates
The economic recovery is picking up as businesses are reopening, customers are returning, and as a result supply chains are under pressure. This leads to a rising inflation rate in the US. The biggest price increases are recorded for energy, (used) cars, apparel, food, and transportation services.

While the Federal Reserve keeps an artificially low interest rate of 0.25% to stimulate economic activity, the increase in the inflation rate of 5.4% is alarming. A rising inflation rate means that goods and services are rising in price, and when income does not rise equally, this can slow down the economy.

If the inflation rate keeps rising, the Federal Reserve can increase the interest rate to discourage borrowing money. This will make loans and leveraged investments more expensive, thus less attractive to have debt capital. Existing loans and leveraged investments will then be built off which can cause an adverse effect on the stock market.


Unemployment

After the sharp rise of unemployment in early 2020, it is already decreased to 5.2% in August 2021. Conditions in the labour market are improving and this is absolutely a positive signal, however, it is still far from pre-pandemic levels of 3.5%.

Governmental assistance keeps many businesses operational and there are concerns that some businesses won’t be able to survive when financial assistance comes to an end. After that, broad concerns are that the number of bankruptcies will rise together with jobs that will go lost. On the other side of the table, unemployed people are not entitled to their jobless aid from September 6th onwards. However, States are given the possibility to keep providing this income support if unemployment remains high.

A high unemployment rate is undesirable as a smaller workforce can result in, among others, less tax income, a reduction in consumer purchasing power, and a stagnating GDP.


United States National Debt

The national debt of the US has increased to 28.4 trillion USD in August 2021, which is more than a 20% increase since the start of the crisis.

As the US enacted its financial support programme for businesses and individuals, the pandemic acted as a catalyst for the national debt to reach higher ground. The national debt can be good if it grows parallel to its GDP and if the debt is used for investments that contribute to the future growth of the country. The national debt levels stayed within the 100–105% range in 2013–2019 but when the pandemic kicked in, the national debt to GDP ratio shot up to 136% within a year.

A high national debt to GDP ratio can indicate that the country is less likely to pay back its debt which leads to a higher risk of default. This can lead to a lower credit rating, which means borrowing money will be more expensive. Furthermore, a study of the World Bank suggests that a country can experience slowdowns in economic growth if its debt to GDP ratio exceeds 77% for longer periods.

3. US Bond Market

The US treasury yield curve is upward sloping, which is a sign of a healthy bond market. However, the yields on longer-term bonds are falling since the last half-year. One of the reasons why the longer-term yield is dropping could be related to the fear that inflation will force the Federal Reserve to tighten its current policy faster, which can slow down the economy.

When the yields on longer-term bonds drop below the yields of shorter-term bonds, then we are dealing with an inverse yield curve which can signal a recession. In this scenario, investors are shifting to longer-term bonds because they have less faith in the short-term economy.

We are nowhere near an inverse yield curve yet, but the sentiment of investors may have the power to influence the stock market as a self-fulfilling prophecy.

4. Sentiment

Ray Dalio is a legendary investor who analysed a lot of bubbles in his 50+ years of investing experience. He formulated 6 ingredients indicators for identifying a bubble.

As some stocks are more in a bubble than others, he distinguishes the stock market in Total Market and Emerging Tech. According to Dalio, the prices of emerging tech stocks are driven up to prices that are less sustainable compared to stocks in the total market. This is, in part, caused by the recent large influx of speculative investors, especially in the tech sector. This group of investors have been driving up stock prices of tech companies blindly, which is something to worry about.

The upper chart shows the total debt (government, businesses, households) to GDP ratio. The bottom chart shows a blue line that indicates the dropping interest rates and the red line displays the printing of money that flows into the public.

Currently, we have a high debt ratio, a large increase in debt, low interest rates, and we’re printing more money than ever before. These are key elements of a bubble as a lot of liquidity is flowing into the market and there is a lot of purchasing of assets such as stocks.

Bubbles can expand and contract. And according to Dalio’s criteria above not a lot of stocks are in a bubble, but the emerging tech stocks are something to watch out for.

Michael Burry is the founder of Scion Asset Management and he rose to fame by betting against mortgage securities before the 2008 crisis, on which the film The Big Short is based. He warns meme stock investors and investors in cryptocurrencies about the ‘Mother of All Crashes’. He suggests that speculation fuelled by government stimulus programmes cannot drive up asset prices forever, while pointing at, among others, Tesla, GameStop, Bitcoin, Dogecoin, and the US housing market.

What Google users are searching for
The perspectives of influential investors on the market are always interesting and what they have to tell about the market is very informative. I am grateful to be able to listen to their take on the current stock market, but what I find equally compelling is what is going on in the mind of the community. The search terms for ‘market crash’ and ‘recession’ increase strongly before and during a market crash. And looking at the current trend, there are no indications of bearish sentiment.

5. Record High Stock Sales

Money-losing companies take advantage of the rise in their stock price, as roughly 750 unprofitable companies sold shares in the secondary market during the past 12 months.

One of the methods for a company to raise capital, it by selling more of its stock. The reason for this can be that the company wants to raise extra capital to reinvest in growth or expansion, or it can be a sign that the firm is in financial trouble, uncertain about its future, or if the company believes its own stock is overvalued at its current share price.

Stock sales can be for one or multiple reasons. However, in the last two periods where this happened, the S&P 500 index was either at the start of a bear market or was already in one.

Conclusion: What’s Next

The burning question investors have is: what is going to happen with the stock market?

Even with all the above-mentioned indicators, it is not possible to predict the near future of the stock market. There are some indicators such as the rising inflation, S&P 500 PE ratio, the Buffet Indicator, and the analysis of Ray Dalio that can be worrisome. These factors are troubling forecasts for the stock market or certain segment(s) of the market. Above this, Michael Burry speaks of the Mother of All Crashes that is yet to come.

On the other hand, with the Federal Reserve on standby, decreasing unemployment and a healthy bond market, the market itself isn’t screaming bad news. Google users also aren’t very concerned.

A market correction will and should be coming but we don’t know when exactly. A correction provides the opportunity for the stock market to recalibrate itself to healthy levels. And honestly, I prefer to have this sooner rather than later, to minimize volatility in the stock market and to minimize the chance of our current stock market becoming a bearish market. Besides, a correction offers the opportunity to buy stocks with a discount. Therefore I always recommend having some cash at hand to safeguard yourself and to be able to buy well-researched stocks or ETFs at a discount during a correction, or in the event of a crash.