With the Dow closing above 16,000 for the first time on Thursday, up 22% for the year and continuing to rise this morning, we’re hearing more and more folks argue that stocks are overvalued and primed for a fall. Some of you have raised a similar concern, which is totally understandable, but I don’t want you to worry.
The truth of the matter is that the small cap arena is a bit frothy due to the reason I’ve talked about before: exchange-traded funds (ETFs) that indiscriminately buy all of the stocks in the index they track. You also have relentless marketing from aggressive indices (like the QQQ, equally weighted ETFs and fundamental ETFs), and the inflow of money has caused a valuation bubble to form under some stocks. We’ve mentioned Tesla (TSLA) as a prime example.
That’s fine. It is the seasonally strong time of year for small caps, and I pay close attention to valuation in any stock that I invest in or recommend. To me, the more important trend is that since late September there has been an unabated flight to quality that actually accelerated a bit in recent weeks during earnings reporting season.
So the bottom-line is those who own “crap” with poor sales and earnings should be afraid, and those who own frothy stocks are seeing their bubbles continue to burst as the flight to quality persists. However, if you own fundamentally superior stocks without excessive valuations you can relax and expect to continue benefitting from persistent institutional buying pressure.
The financial media is having fun trotting out those warning of problems ahead. On Tuesday, CNBC reported that Carl Icahn expressed some concerns about the record highs when he said that the market could suffer a big decline, valuations are rich, and earnings at many companies are fueled more by low borrowing costs and share buybacks than management’s efforts to boost results.
Well, I won’t disagree with him on the importance of low borrowing costs and share buybacks.
I also found it interesting that Icahn said his investment funds would have performed better since 2009 if he had not hedged as much as he did, and that “picking short-term moves in the market is like predicting how many sevens the “hot’ dice player will continue to roll.” Interestingly, Icahn also said, “It is almost impossible to predict what a market will do in the short term. There are too many variables.”
Other investors, including Jeremy Grantham and perennial bear Marc Faber, also appeared in the media and expressed concerns. Goldman Sachs (GS) also weighed in, saying that given the S&P 500’s big run this year, the index could fall 6% in the next three months and 11% over the next 12 months to levels of 1,700 and 1,600, respectively.
I thought the Goldman report was well-written and detailed. It said that returns in 2014 would depend on earnings and money flow. That’s true, and if you own stocks characterized by outstanding earnings and persistent institutional buying pressure, you shouldn’t fear Goldman’s forecast.