GameStop (NYSE:GME) shorts once again had their heads handed to them on Wednesday in a short squeeze of epic proportions that had GME stock up almost 135% on the day.

This illustrates why the markets are incredibly expensive at the moment. Investors ought to tread carefully. 

Here’s why.

GME Stock is a Symptom, Not the Cause

GameStop’s fall from grace before the pandemic had been so great that I’d given up hope that GME stock could be revived. Boy, was I wrong? 

The official start of the novel coronavirus began on March 11, 2020, when the World Health Organization declared it to be a pandemic. GameStop shares closed trading that day at $4.14.  

Now trading at $347 – it’s changing by the minute – you would think the company had just announced it’s been acquired by Apple (NASDAQ:AAPL) or some other high-tech behemoth. 

Alas, that’s not the case. Rather, the retail investor has gotten heavily involved in trading this stock, regardless of the valuation. 

“It doesn’t make business sense,” said Doug Clinton, co-founder of Loup Ventures. “It makes sense from an investor psychology standpoint. I think there’s a tendency where there is heavy retail interest for those types of traders to think about stocks differently than institutional investors in terms of what they’re willing to pay.”

Ryan Cohen Still Has a Lot to Prove

GameStop reported its Q3 results in early December. Online sales were good. Brick-and-mortar were horrendous. Overall, sales declined by 30.2% year-over-year. For the trailing 12 months ended Oct. 31, GameStop’s sales were $5.2 billion. That’s a price-sales ratio of 1.6x. Hardly outrageous.

However, when you consider that analysts don’t think it will make money until 2023, it’s hard to know what retail investors see in the video game retailer. Much of the traffic has been driven by a Reddit chat room called wallstreetbets who are shorting hedge funds that bet on GME shares to fall.

There’s been chatter around Chewy (NYSE:CHWY) co-founder Ryan Cohen joining the board as a reason for the excitement. 

“It has become a cult stock because of Ryan Cohen’s success with Chewy,” Wedbush Securities analyst Michael Pachter said about Cohen’s recent involvement. “I cannot discount Mr. Cohen’s past successes and don’t know what he has in mind going forward, but I need to see their strategy before I give them credit for materially higher earnings power.”

Before you get all hot and bothered over Cohen’s presence on the board, it’s important to point out that Chewy only made $5.5 million in adjusted EBITDA in the third quarter on $1.78 billion in quarterly sales. Further, over the past three fiscal years, Chewy’s lost $858 million from operations. The final verdict on the company and Cohen has yet to be written. 

Investors are getting way ahead of themselves on GME, and that’s a reflection on markets that have gotten extremely frothy. 

How Frothy Have They Gotten?

Do an online search for “how expensive is the stock market right now?” You’ll get more than 1.5 billion results. 

One of the stories that jump out at me is a CNBC piece highlighting Goldman Sachs’ take on market valuations. The investment bank runs down 10 valuation metrics of the S&P 500 in relation to their historical values. The median metric is 94% of the index’s highest levels from an aggregate point of view and 100% based on the median stock in the index. 

For example, free cash flow (FCF) yield, something I’m always considering when looking at investing in a company, is 3.5% based on an aggregate and 3.7% on the median stock. Historically, the current aggregate FCF yield is 62% of the highest point recorded or 2.2%. Typically, I consider a value stock to be anything above 8%. 

Goldman Sachs points out that based on a current enterprise value to earnings before interest, taxes, depreciation and amortization (EBITDA) of 17x, S&P 500 stocks have never been more expensive. The same goes for EV/sales at 3.2x.

Economist Robert Shiller is best known for developing the CAPE ratio, which is short for cyclically adjusted price-earnings. It cuts out the ebbs and flows of earnings by averaging them over a 10-year period. 

The CAPE ratio is 34.1. The only other time it’s been this high was in 2000. Critics of the ratio feel it doesn’t take into account prevailing interest rates. To remedy that, Shiller’s created the Excess CAPE Yield, which is the S&P 500 earnings (the “E” in P/E) divided by the S&P market capitalization (the “P” in P/E), less the inflation-adjusted 10-year Treasury yield. 

While the current CAPE yield is 2.85%, the Excess CAPE Yield is 56 basis points higher at 3.41%. That’s 229 basis points higher than the 10-year Treasury. Adjusted for inflation of 1.68%, the long bonds delivered a real return of -0.56%.

So, the argument goes, stocks are a much better buy than bonds at the moment despite being at or near historically high valuations.

The Bottom Line

Rob Arnott is the head of Research Affiliates, a leader in smart beta and asset allocation. He said it best about the current state of the markets.

“Saying that stocks are pricey and bonds are worse is not a reason to go out and buy stocks,” Fortune reported Arnott saying recently. 

You can put your head in the sand and ignore the warning signs. Or you can listen to people like Arnott who are paid to be right about valuation. 

The mere fact GME jumped by so much suggests sanity has left the markets. I wouldn’t touch GME stock with a 10-foot pole.

If you want to play the video game industry, Electronic Arts (NASDAQ:EA) or Sony (NYSE:SNE), or one of the other large-cap participants, is a much safer way to do so. 

On the date of publication, Will Ashworth did not have (either directly or indirectly) any positions in the securities mentioned in this article. 

Will Ashworth has written about investments full-time since 2008. Publications where he’s appeared include InvestorPlace, The Motley Fool Canada, Investopedia, Kiplinger, and several others in both the U.S. and Canada. He particularly enjoys creating model portfolios that stand the test of time. He lives in Halifax, Nova Scotia. At the time of this writing Will Ashworth did not hold a position in any of the aforementioned securities.