Hyman Minsky characterized euphoric, frothy and irrationally exuberant markets as the necessary underpinnings of stability that fuel speculative manias. In short, conditions of low uncertainty when market participants are lined up on one side of the market provide the breeding grounds for instability, the formation of market tops and the subsequent sudden precipitous decline in asset prices. This post touches a little more on that.
Back in February 2024 we wrote a blog post “Is the S&P 500 Overvalued Now? Insights Into How We Navigate the Markets,” in which we referenced “when the market price action triggered a well specified breakout above 4800, we identified a probability over the medium/long term that the S&P 500 could grind its way to 6100 and become extremely overvalued along the way.”
Presently, since the S&P 500 has been pushing up against our 6100-upside price target from February 2024, we thought it was an opportune time to provide some further market insights to help navigate the wide range of potential market outcomes.
At the time of this writing, fundamentally speaking, the earnings yield of the S&P 500 is roughly 3.3% with the 10 YR Note (considered the risk-free rate of return) yielding roughly 4.6%. This formulates a negative value for the equity risk premium, meaning the investor is theoretically losing money (relative to the risk-free rate of return) by taking a risk in equities.
Back in February 2024, the equity risk premium was roughly negative 0.7 and currently it stands at roughly negative 1.3. This is almost a 100% decline in the equity risk premium in roughly 10 months.
Similarly, the dividend yield of the S&P 500 is roughly 1.2% with the 10 YR Note yielding roughly 4.6%. The cost of capital is now almost 4 times the return on capital measured by dividends.
Furthermore, the dividend yield of 1.2% for the S&P 500 is very much at the low end of its historical range with the percentage of individual stocks in the S&P 500 with a dividend yield greater than the 10-YR Note yield also being at the very low end of its historical range.
Additionally, investment grade and junk bond spreads relative to the 10-YR Note have tightened considerably and appear to be mispricing the risk of calamity.
When gauging market sentiment, the current value of the VIX being roughly 16 suggests low uncertainty, but still far from terminal values in a range around 10. On the flip side the PUT/CALL Ratio is at the very low end based on historical values, suggesting extreme market optimism.
Thus, the weight of the evidence suggests the S&P 500 is extremely overvalued. Now it is important to understand that valuation is a poor timing mechanism in the short term as market prices are buoyed more by the popularity of issues and pervasive sentiment governing markets.
When we apply our proprietary technical analysis to the S&P 500 on a medium/long term basis, the market price appears to be in an uptrend that is mildly strengthening yet has not triggered a terminal extreme, absent overhanging institutional pools of resistance, with our 6100-price target still intact. On the flip side, medium term institutional pools of support appear around 5721 and 5333. Now if market calamity strikes, we see a probability the market price could test strong institutional pools of support around 4800 and 3500.
Furthermore, while there is a very low probability, in the event of extreme market uncertainty and a severe bear market, we anticipate long term institutional pools of support around 2150. We would celebrate these price levels as potential generational buying opportunities.
As long-term investors in an extremely overvalued market, we retain a market neutral stance in the S&P 500 combined with prudent risk and portfolio management. However, this market neutral stance could change in a timely way for a multitude of reasons with the risks to the downside appearing asymmetrically greater than the reward to the upside.
As a steward of capital through all markets, The Practical Contrarian wins by applying a thoughtful, thorough and disciplined approach to help institutional investors navigate the wide range of potential market outcomes to maximize their potential.
If your hedge fund, family office or other financial institution needs guidance on creating customized, data-driven approaches to investing in the S&P 500 or anything else we are here to help and only a click away.