Is It Time to Short the Market?

I’m feeling a little queasy about the market these days, even though it has been doing really well for the past few months.

The advantage of writing five or more articles a week on the stock market is that I get to observe a broad spectrum of stocks and their valuations. What I’ve seen lately in both my articles and those of my colleagues is that a lot of individual stocks are not just overpriced but way overpriced. In some cases, these stocks are still way overvalued even after accounting for dividends, lots of cash on the balance sheet, and regularly strong free cash flow.

That alone isn’t necessarily sufficient to cause me to reach for the red “short the market” button. What concerns me here is that economic data are not strong, yet everyone is behaving as if they are.

In my economic analysis, I always look to unemployment as being an important metric. I do not, however, make the mistake everyone makes when they listen to media reports on the unemployment rate. The number that gets reported is the number of unemployed people who are actually out looking for work. It does not measure the number of people who have given up looking for work and have exited the workforce.

So while the unemployment rate has been slowly declining, which is good news, the number of people who have left the workforce is at an all-time high — and that’s really bad news. It’s bad because I believe we live in a consumer-driven economy, and if more people aren’t in the workforce, they aren’t spending as much money.

There’s another reason stocks are booming. The Fed has been buying bonds for an extended period, forcing the yields down. With the opportunity for capital gains now mostly used up, capital gains are best found in stocks. The same is true for fixed-income investors. Why invest in bonds when you can get a yield in a stock? Thus, money is artificially flowing into the market.

Some folks point to corporate profits as justifying the run-up. True, many companies are organically growing and deserve higher valuations. However, it’s important to note that many companies have enormous amounts of cash on hand and some have been aggressively buying back stock. This results in a decrease in the number of shares outstanding, which artificially pushes the net income per share result higher.  It’s always good when there are fewer shares, since you own more of the company as a result, but just be aware how that translates to the bottom line.

Of course, if you have a long-term diversified portfolio, none of this should matter. But even then, some people like to hedge their bets. Other folks who trade the market on occasion, however, may have a short opportunity on the horizon.

So if we do have a correction, how large might it be?  There’s about 7% between the S&P’s Monday close of 1,382 and the 200-day exponential moving average at about 1290. The next stop would be around both the weekly and monthly long-term trend lines at 1,200. That’s about a 14% decline. After that, you’re looking at 1,000 or lower.

The P-E ratio of the S&P 500 is now at 23.31. The long-term mean is 16.42, suggesting we are some 30% overvalued in relation to the long-term average. I think aggressive traders could open a short position here using the ProShares Short S&P500 (NYSE:SH) and then moving to the 2x leveraged position via ProShares UltraShort S&P500 (NYSE:SDS) on a break below 1,275 on heavy volume.

You’ll also want to start making a shopping list of stocks you want to buy that are currently overpriced. A big drop would give you (and me) the chance to scoop up stocks such as Apple (NASDAQ:AAPL), Google (NASDAQ:GOOG), Walt Disney (NYSE:DIS), Philip Morris International (NYSE:PM), General Electric (NYSE:GE), and Dollar Tree Stores (NASDAQ:DLTR).

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities.

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