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Stock Market Bubble: Are Stocks Too Expensive Right Now?

By David Butler – Updated Sep 14, 2020 at 10:24AM

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Simply put, the stock market has gone wild. It's important to factor that into your investment planning.

Despite the COVID-19 pandemic and related shutdown, despite the shock to employment, despite the economic uncertainty globally, and despite a decade-long expansion, the stock market just keeps going up.

The Wall Street Journal recently reported that the P/E ratio for the S&P 500 based on the trailing 12 months of earnings is 25.6, while the P/E based on forecast future earnings would be at levels that were last seen in the year 2000. Remember, 2000 was followed by a three-year market slump.

The disproportionate nature of the market rally is even more concerning. Little more than 25% of stocks in the S&P 500 are actually up for the year. The bull run has been dependent on a small portion of stocks. Principally, tech has been the saving grace.

The exterior of a building with three American flags, and a street sign for Wall St.

Image source: Getty Images.

This year's rally has been increasingly one-sided

While not all of the first- and second-quarter earnings reports from the various publicly traded companies have been as bad as some had anticipated, the multiples for some of the best performing names this year are staggering. Investors have rushed into any equities with pandemic growth potential.

Zoom Video Communications (ZM -0.62%) is a good example. The stock is up over 200% in the last six months; and that is after the pullback that we've seen over the last week or so. In relation, the company is only expecting adjusted full-year earnings of $2.40 to $2.47 per share. That means the stock is trading at roughly 165 times its full-year earnings forecast.

Perhaps the biggest example of the disconnect between financial reality vs. market speculation is Tesla (TSLA -0.74%). The stock is up 338% even after its recent correction. The shares carry a market capitalization of just under $342 billion, while total equity on the balance sheet was $9.85 billion at the end of June. Think about that. Investors have $342 billion in an entity that is worth $9.85 billion in book value, and it is only now working toward what might be a slightly profitable year.

Look at the economic circumstances

There's a big tug and pull going on right now between stimulus and fundamentals. The measures being implemented to drive the economy (like low interest rates) make it difficult for investors to find big growth potential outside of equities. Low rates make bonds and Treasury notes a weak play. It also hinders financial institutions. Overall, investors have to look to the small number of growth names within the stock market to find returns.

The stock market is not the economy. It is incredibly important to remember there is a disconnect between the two. The stock market is a speculative valuation market for components of the economy. Gross domestic product fell by 32.9% in the second quarter, while the S&P 500 climbed more than 500 points. That should pretty much showcase what I'm talking about.

Consumer spending has been important for the U.S. economy. The unemployment shock has been tempered by the stimulus measures which included increased unemployment benefits and business loans. As The Wall Street Journal reported, consumer spending growth has gradually slowed over the last three months, going from 8.6% growth in May to 6.2% in June and 1.9% in July. It doesn't take a lot of thought to connect the decline with a decline in spending stimulus money.

There is also debate over where the U.S. unemployment rate truly lies. Some have suggested that if you include the issues with data collection, combined with the part of the workforce that is not presently looking for work (a figure that the unemployment rate traditionally excludes), the actual unemployment rate for August could have been 11.1% rather than the reported 8.4%.

Even with a rate of 8.4%, that is close to the levels the country was at during the low point of the Great Recession. As a whole, the number of people in the workforce is still down around 3.7 million compared to what it was before the COVID-19-related chaos began.

Because the strength of the consumer is such an important factor in the U.S. economy, it's important to monitor these issues. While unprecedented stimulus bolstered a weak situation, the economy is not out of the woods yet. 

The case for cash

When everything costs an arm and a leg to buy, it's wise to be a little more selective. Economic factors have not kept up with the market's insane rally. It seems prudent to start considering a larger cash position. Being fully invested at a market high can lead to dilemmas down the road. It leaves you with no maneuvers if a market correction occurs. That in turn can lead to taking losses in order to free up capital. It is far better to have some cash to invest on the sidelines. It turns a pullback into a buying opportunity rather than a detriment.

David Butler has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Tesla and Zoom Video Communications. The Motley Fool has a disclosure policy.

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