Investors, having seen the light, race towards it with great expectations. The S&P 500 and the NASDAQ are, once again, near all-time highs. By the look of the lofty stock market indexes, the American economy must be operating at full tilt.
But what if the light investors are racing towards is not the promise of riches they’re expecting? What if it’s the headlight of a freight train locomotive that’s headed right towards them?
The Cyclically Adjusted Price-to-Earnings (CAPE) ratio, which was developed by Nobel laureate Robert Shiller, looks at real per-share earnings over a 10-year period to measure valuation. Right now, the S&P 500’s CAPE ratio is above 40. To give you some perspective, the historical mean is around 17.
There is only one other time in the history of the United States stock market that the CAPE ratio has been higher than it is today. That was December 1999 – at the peak of the dot-com bubble. When that bubble burst, it destroyed trillions of dollars in wealth.
Today, we are approaching those same manic levels of overvaluation. Yet investors don’t seem to be appreciating the risks they are taking. They’re assuming a quick peace in the Middle East, low inflation, falling interest rates, and rising earnings decades into the future.
This dangerous optimism ignores the structural weakness of a global economy propped up by record debt, cheap energy, and free flowing trade. If inflation continues to rise or if corporate margins finally buckle under persistent cost pressures, this speculative fever will break, leaving overexposed portfolios devastated by a sudden, violent reversion to the mean.
Here’s one part of the reality that’s being ignored…
Hormuz Headache
While Wall Street is celebrating its AI-driven gains, something much more primitive is happening in the Strait of Hormuz. The world’s most important oil chokepoint, where about a fifth of the world’s total oil consumption passes, remains severely limited. The two-week ceasefire came and went without a deal. Bomb dropping has yet to resume, for now.
For decades, the possibility of an oil shock has been a menace to the global economy. When energy costs spike, the price of everything else follows. The dollars needed to fill up your SUV, the price of plastic goods, the cost of the fertilizer needed to feed the world, and the fuel for the ships that bring products across the Pacific.
An oil shock is an instant tax on every single human being on the planet. Yet, looking at the market indexes, you’d think crude oil was no longer the essential cornerstone of the global economy. What will happen when consumer prices spike above a double-digit annual rate?
Remember the word transitory? In August of 2021, after consumer prices had become uncorked, Fed Chair Powell assured us that the post-pandemic price spikes were just a temporary glitch. Yet this supposed temporary anomaly has had a long-term impact.
Once again, consumer price inflation is on the move. In March, per the consumer price index (CPI), prices are rising at an annual rate of 3.3 percent. This is well above the Federal Reserve’s inflation target of 2 percent.
Of course, when inflation rises, the Fed’s hands are tied. The central bank can’t cut rates to save a sagging market or boost the economy without risking a 1970s-style inflationary spiral. Investors are betting the Fed will pivot to lower rates later this year. But with inflation returning, the Fed may have to hold or even raise rates to keep things under control.
Younger, Smarter, Better Looking
Those decisions will likely fall on likely incoming Fed Chair Kevin Warsh, who went before the Senate Banking Committee confirmation hearing this week. Warsh is younger, smarter, and better looking than outgoing Fed Chair Powell. He’s also much richer. His net worth is well over $100 million.
Does he have bigger stones than Powell? Does he have the wisdom that Powell lacks? The answers to these questions will be revealed in due time.
Regardless, Warsh will have his hands full. He’ll start his new job at a time when investor expectations are completely disconnected from reality.
How can rational people look at a CAPE ratio of 40, a crippled global shipping lane, and rising energy and inflation, and decide that now is the perfect time to buy more stocks?
As Warren Buffett elaborated, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” And right now, the vote is to chase prices higher for fear of missing out (FOMO).
We are seeing a generation of investors who have been conditioned by fifteen years of buy the dip. Every time the market faltered since 2008, central banks have stepped in with an abundance of liquidity. This has created a twisted response, where bad news for the economy is good news for the stock market. Because bad news means more stimulus.
But the rules of the game have changed, and many investors don’t realize it. You can’t print your way out of a supply-chain collapse in the Middle East, and you certainly can’t print your way out of high inflation. In fact, spraying liquidity into inflation adds fuel to the fire.
From Euphoria to Despair
History is a cruel instructor. For she gives the test before teaching the lesson. The disconnect we are seeing today has all the hallmarks of an epic bubble. High valuations, little appreciation of risk, extreme confidence, and ignorance of reality. All the while, the smart money is looking for the exit.
We are facing a convergence of risks that are not being priced in. An extended closure of the Strait of Hormuz, for example. This could send oil to $150 a barrel. Rising inflation that sends bond yields higher, making that 40x earnings multiple look absolutely insane.
The margin for error is zero. When you are priced for perfection, even a pretty good reality feels like a disaster.
Does this mean the crash happens tomorrow?
Maybe. But probably not just yet. Bubbles tend to last longer and inflate much more than any honest person could possibly fathom. Those operating with a healthy measure of humility are wise to take some chips off the table.
The fundamentals haven’t been abolished. They’ve just been ignored.
Still, gravity is a law. Not a suggestion. Eventually, the market will have to reconcile with the reality of energy costs, the reality of inflation, and the reality that you cannot pay sky-high prices for earnings indefinitely.
Markets always revert to their mean. Moreover, to do so, they must overshoot to the downside too.
The pendulum of excess never stops at the center. It swings from manic euphoria to paralyzing despair. When the correction finally arrives, the same crowd currently blinded by greed will be consumed by panic.
Protecting capital now isn’t just a strategy. It’s an act of survival before the inevitable, face-ripping descent begins.
[Editor’s note: Get a free copy of an important special report called, «Cash Machine – Why You Should Own this Mineral Royalty with a 12% Yield,» when you join the Economic Prism mailing list today. If you want a special trial deal to check out MN Gordon’s Wealth Prism Letter, you can grab that here.]
Sincerely,
MN Gordon
for Economic Prism
Return from Priced for Perfection in an Imperfect World to Economic Prism
