Daily Gains Letter

Investment Risk Alert—Stock Market Set to Be Overvalued

By for Daily Gains Letter | Feb 7, 2013

DL_Mitchell_070213The stock market has a problem, and it could be a big one. While the main stock market indices are testing new highs, earnings growth remains elusive. I’m not talking about earnings maintenance, but real earnings growth based on real revenue growth. The fourth quarter of 2012 produced terrible gross domestic product (GDP) numbers, and I have to say that I think the stock market is very vulnerable to a major price correction this year.

Accordingly, I think savers and investors need to be highly cautious over the near term. The stock market’s recent strength has a few more legs, but once the current earnings season is over, the market will go back to worrying about sovereign debt, unemployment, gridlock in Washington, and trouble in the Middle East. There is an earnings-related stock market correction in the making this year, so I wouldn’t be a big buyer of equities right now.

At this time, there are countless blue chip, dividend paying stocks that are trading right at their 52-week or all-time highs. Intuitively, it isn’t a great time to be taking on new investments, especially in the best stocks the market has to offer.

For most equity investors with a portfolio of stocks, I would just sit on the sidelines and enjoy the current gains. Valuations aren’t stretched just yet, but they could be soon—because earnings growth is proving to be so minimal.

We know that the stock market is very good at betting on the future, and this is what’s going on right now. We’ve seen improvement in some economic indicators, even in Europe and in China. But all the current “good news” is based on the massive, artificial inflation created by the Federal Reserve, and there’s nothing more that the central bank can do. In addition, government spending is on the chopping block, because there is too much debt in the system. Fourth-quarter gross domestic product (GDP) revealed just how fragile the U.S. economy is when defense spending is reduced. The world and the U.S. economy still have enormous structural problems to digest; and with the stock market hitting multi-year highs, the risk for new investments is very high. How can earnings grow in an environment like this?

For long-term investor saving for retirement, a substantial correction in the stock market would be a healthy development. Investors could then add to existing positions and take on new ones in good companies at a fairer price.

In 2008/2009, we almost lost the entire financial system, due to overindulgence in subprime mortgages and the resulting derivative instruments used to spread this unstable debt around the world. The damage from the lack of oversight of these instruments is still being felt, and the fact of the matter is that we do not know how exposed our major financial institutions are in the derivatives market at present.

There is a lot of potential for disaster going forward, which isn’t to say that the stock market hasn’t recovered nicely from its previous highs. Practically, corporate earnings have to begin accelerating or the stock market will become overvalued and the probability for a correction will increase dramatically. A good dose of caution is worthwhile over the near term. The stock market has already gone up, and earnings growth is minimal.

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