Why this strategist says the market is in a bubble

Summary

Doug Ramsey, Chief Investment Officer at LPL Group, discusses the current state of the stock market, describing it as a bubble based on various historical valuation metrics. He points out that while earnings growth may support valuations in some sectors, especially small and mid-cap stocks, large-cap stocks may struggle with margin expansion. Ramsey is skeptical of the bullish outlook for mega-caps but sees greater value in smaller, value-oriented sectors like financials. He is rotating away from tech stocks and increasing exposure to regional banks and insurers, indicating a shift towards value stocks in the current market environment.

Takeaways

• 😀 Doug Ramsey, Chief Investment Officer at Luthold Group, views the current stock market as a genuine bubble, based on various valuation metrics.
• 😀 Historically, whenever the market has traded above 21 times forward earnings, it has been considered a bubble, which is the case now in 2024.
• 😀 The market's valuation is also above historical averages for cash flow, with the current ratio at 20 times, reinforcing concerns about a bubble.
• 😀 Doug Ramsey uses a 'normalized PE ratio,' which is a five-year smoothed earnings ratio. At 32.5 times, it is in bubble territory, as any time it has exceeded 30, it has signaled a market bubble.
• 😀 Despite a more subdued retail enthusiasm compared to past bubbles like the 1999 tech bubble, the empirical data suggests that the market is still in bubble territory.
• 😀 Ramsey is skeptical of the view that earnings growth will be strong enough to justify further increases in valuations, especially for large-cap and mega-cap stocks.
• 😀 While small and mid-cap stocks' valuations are more reasonable, Ramsey suggests that their future returns might be average or just below average, depending on the macroeconomic environment.
• 😀 Ramsey’s forecast for S&P 500 returns over the next several years is around 3%, signaling a more cautious outlook for large-cap stocks.
• 😀 In contrast to the large-cap growth dominance, there is a rotation happening toward value stocks, particularly in sectors like financials and regional banks.
• 😀 Luthold Group's portfolio is currently underweight in tech stocks and is shifting towards financials, including regional banks, reinsurers, and PNC insurers, due to favorable quantitative signals and market dynamics like higher interest rates.

Q & A

What does Doug Ramsey believe about the current state of the stock market?

Doug Ramsey believes that the stock market is currently in a bubble, based on high valuation levels. He compares the current market to previous bubble periods like 1999 and 2021.

How does Ramsey quantify the stock market bubble?

Ramsey uses several valuation measures, including the forward P/E ratio, cash flow ratio, and his firm's normalized PE ratio, to argue that the market is in a bubble. For instance, he points out that the market is trading above 21 times forward earnings and 20 times cash flow, which historically signals bubble conditions.

What is the significance of the 21 times forward earnings and 18 times cash flow thresholds?

Historically, when the market has traded above 21 times forward earnings and 18 times cash flow, it has signaled bubble-like conditions. These thresholds have been seen in previous bubble periods, like the dot-com bubble in 1999 and the post-COVID bailout surge in 2021.

What is the Luthold PE ratio, and why does Ramsey mention it?

The Luthold PE ratio is a five-year smoothing of earnings used by Ramsey's firm to assess stock market valuation. Ramsey mentions it because it currently sits at 32.5 times, which historically has also signaled bubble conditions when above 30.

How does Doug Ramsey feel about the argument that earnings growth will offset high valuations?

Doug Ramsey is skeptical of the argument that earnings growth will be sufficient to overcome the high valuations in the market, especially for large-cap stocks. He believes that margin expansion from here is unlikely and that earnings growth alone will not justify current valuations.

What does Ramsey say about the potential of small and mid-cap stocks?

Ramsey sees small and mid-cap stocks as potentially offering better value compared to large-cap stocks, although he predicts that their future returns will likely be average or just below average. He emphasizes that while valuations in these sectors are more reasonable, there are concerns about a potential recession.

Why does Ramsey suggest avoiding large-cap growth stocks?

Ramsey suggests avoiding large-cap growth stocks, particularly in the tech sector, because of their overvaluation. He has reduced his exposure to tech stocks in recent months and is now underweight in tech relative to the broader market.

What sectors does Ramsey favor, and why?

Ramsey favors value-oriented sectors, particularly financials. He has increased his allocation to regional banks, reinsurers, and property and casualty insurers. He believes these sectors are benefiting from higher inflation and rising interest rates, which have positively impacted their performance.

What does Ramsey think about the potential of the financial sector?

Ramsey sees strong potential in the financial sector, particularly regional banks and insurers. He believes that higher interest rates and inflation are likely to benefit these sectors, leading to better performance compared to other areas of the market.

What does Ramsey predict about the leadership in the stock market?

Ramsey believes that the leadership in the stock market is shifting away from large-cap growth stocks, especially tech, and towards value stocks and smaller, mid-sized companies. This shift is seen as a rotation in market leadership after a prolonged period dominated by large-cap growth stocks.