Time to Be Concerned

 | May 23, 2013 | 4:00 PM EDT  | Comments
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If the stock market doesn't scare you at least a little, you must not be paying attention.

Before the late swing positive, we saw selling today in the wake of the Japan's Nikkei 225 selloff overnight after the China Purchasing Managers' report. And concerns late Wednesday about the Federal Reserve stopping its bond buybacks if the U.S. economy continues to gain momentum sent indices sharply lower by the close. I am not a market timer by any stretch of anybody's imagination, but I saw red flags all over the place as the market worked higher. It reminded me a little of 2007 when the prices on the screen didn't match what I saw outside my window.

In the past few weeks what I consider troublesome comments came from billionaire investors Seth Klarman and Sam Zell about the shakiness of the stock market and the economy. Klarman pointed out that investing looks easy right now. Just buy the dip and wait for Permanent Open Market Operations (POMO) to bail out your position by forcing even more money into the market. Buy the dip, enjoy the ride. When investing looks easy, he said, it is the most dangerous.

Zell was even more blunt and said that the disconnect between the economy and stock prices was a game of musical chairs, and those caught without a chair when the music stopped would be hurt. Both men have passed the biggest tests of investment acumen by surviving and thriving for a very long time. Like E.F. Hutton, when they speak, people should listen.

In my readings around the Internet I see Tobias Carlisle, author of the excellent Quantitative Value, pointing out that the total-market-capitalization-to-GDP ratio has now surpassed the 2007 highs. I cannot think of a single economic justification for stock prices to be so high when compared to economic activity, and it's concerning. But it is not a timing measure, and could easily go higher before collapsing. It does usually collapse when it reaches high level, and the eventual collapse worries me far more than missing any short-term upside. The last two times the total market ratio exceeded GDP were 2007 and 1999. That's a wakeup call.

I have my positions in very cheap stocks and I am not going to sell them, as I really do not time markets. I spent some time this morning thinking about what investors should be avoiding right now, regardless of which camp they fall into. No matter how bullish you may be, some stocks have limited upside based on valuation. It is these same stocks that will lead the way lower and have a high chance of crashing if the bearish scenario plays out as expected.

I ran a simple screen looking for stocks that trade at more than 100x trailing and 50x expected earnings. Unless you have cured cancer, developed a friction-free superconductor or invented cholesterol free chicken-fried steak that tastes good there is no business that can sustain that valuation for long. These stocks have fairly limited upside in a continuing bull market and could be an absolute disaster if a bear comes to call.

Once again, the most obvious observation is that the larger and more popular real estate investment trusts have surpassed ridiculous valuations and are now at ludicrous levels. I find it interesting that Sam Zell is chairman of Equity Residential (EQR) and he made bearish comments on both stocks and the housing market. In spite of this, investors have bid up shares of the REIT to 203x earnings and 53x the always highly accurate Wall Street estimates. He does say the multifamily market will do well, but I doubt that the "Grave Dancer" would pay this multiple of cash flow, earnings and asset value for a property. With a dividend yield below 3% and trading at more than 2x book value, there is simply no good reason to own the stock.

I know there is a bullish case circulating for the educational housing REITs right now and the stock prices reflect it. Universities, especially those that are state-funded are not building any more dorms or apartment space in these budget-constrained times. Increasingly they are turning outside the conventional system and REITs are well positioned to benefit. There is also a bearish case based on developing concerns about the student loan markets and the always-spiraling cost of a college education that could limit future enrollments. No matter which story you buy, the 568 multiple of current earnings and more than 200x next year' you pay for Education Realty Trust (EDR) is too high. It's a great story, but its fully reflected and more in the share price.

It's time to be a little concerned about the market. If it is too cheap to own, you should buy it -- but there aren't too many of those opportunities right now. Many stocks should be avoided due to valuations. It's time to consider those and make sure you're positioned to survive.

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