The U.S. Market Is Wildly Overvalued

 | Mar 24, 2017 | 9:00 AM EDT
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As I have noted many times in my Real Money columns, I eagerly anticipate each week's edition of FactSet's Earnings Insight. John Butters and his team present the facts -- just the facts -- in a very clear and concise manner.

It's so easy to get caught up in the daily minutiae of watching the markets and Congress. Last night, for the first time in a while, I had a chance to fully digest Mr. Butters' charts and data.

The main conclusion to be drawn can be summed up in the favorite exclamation of the Millennial generation: Oh. My. God.

As of last Friday, the market was trading at 17.8x forward 12-month earnings. I knew that single data point already, and hopefully you did, too. The real value-added from reading Earnings Insight is the historical information contained in its long-term P/E charts.

The amount of multiple expansion in the past six years has been absolutely astounding. In mid-March of 2011, the S&P 500 was trading at 13.0x forward earnings and about to slide to 11x on lingering concerns about the health of the financial system, particularly in Europe.

That valuation correction was short-lived, of course. It's amazing to see how easily the S&P 500 has chugged through 14x, 15x (which is the average for the past 10 years) then through 16x. After experiencing resistance in 2015 and 2016 at the 17x mark, the index has obliterated that level during the current Trump Jump.

Is there a reason each dollar of corporate earnings is worth 20% more in 2017 than it was in 2015? There is not, and because of that a reasonable person come only come to one conclusion from FactSet's data: The U.S. equity market is wildly overvalued.

That's what investors should focus on. Not whether healthcare reform is passed today, or who was spying on whom during the U.S. Presidential election, or any of these ridiculous, macro-fantastical stories that dominate CNBC and the business headlines.

As new clients join my Portfolio Guru asset management program, I have the happy problem of having new money to invest. Every day, I ask myself: can I really be throwing those dollars toward stocks, with the market trading at 18x forward earnings? Does that make sense? I don't think it does.

That's where nuance is important, though. It's just very hard to pinpoint the exact moment when this market will return to its senses. The biggest problem is the top-down, ETF-driven mentality that fails to recognize the market is made up of individual companies with wildly different fundamental characteristics. But that mentality has taken us from 11x to 18x in six years, and it will not change overnight.

So, I'm not recommending that you sell all your stocks today. I am, however, recommending that you cease committing new capital to stocks. Also, as you harvest gains in stocks after his exuberant rally, I recommend that you reinvestment those profits into corporate bonds and equivalents or stocks that are "bond-like."

Bond-like stocks are those that generate income. I favor companies whose corporate structure mandates that they pay out the vast majority of earnings (which are not taxed) to shareholders in the form of dividends. Real estate investment trusts (REITs) and business development companies that are registered as investment companies (BDC-RICs) are two examples of such "pass-through" stocks.

REITs and BDC-RICs have historically underperformed in periods of rising long-term interest rates, but I am not convinced that we are in one. Put another way, I am much more worried that there will be a day when equity traders decide en masse "18x is too damn high" than I am that bond traders say "a 2.40% yield on the 10-year Treasury is too damn low."

So, I am putting new money into investments that will generate income for my clients and reinvesting currently-generated income in, you guessed it, even more income securities. At times, that strategy can seem stale or even uneconomic, but I believe the next six months will be a terrific time for investors to generate positive relative returns in fixed income vs. equity.

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