Is the Stock Market Dangerously Overvalued?

Another stock market crash cannot be ruled out. Investors should consider the valuations and risk-reward ratio of investing in stocks in this environment.

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Stocks around the world have witnessed a resurgence this month. Since the stock market crash in March, nearly every single company listed on any stock exchange has rebounded. South of the border, the S&P 500 trades at a record high. Meanwhile, the TSX 60 Index is down only 6% year to date. 

This rapid escalation in stock prices flies in the face of what’s happening in the actual economy. Millions of people are still unemployed, while the pandemic hasn’t yet been resolved. In fact, experts warn of another wave of layoffs and infections in the months ahead. 

With this in mind, investors must ask themselves if assets are overvalued and if we could revisit a stock market crash soon. 

Leading indicator

Stocks are basically a leading indicator for corporate earnings. In other words, they don’t reflect the present-day situation but investor sentiment about the future. The stock market crash of late March indicated the economic distress due to the lockdown orders spreading across the world. Now, the stock market is reflecting a quick rebound in the months ahead. 

The stock market isn’t always right. Investors can choose to disagree with the indications. I believe the sentiment about the months ahead is overly optimistic. A stock market crash could quickly reflect any future lockdowns or a slower-than-expected jobs recovery. 

The current ratio of stock market-to-national income (the Buffett indicator) is 115%. Meanwhile, the national income in 2020 and 2021 could be much lower than the previous 12 months. In other words, the stock market is indeed overvalued. 

Sector divergence

A deeper dive reveals that the stock market crash and recent rebound did not impact all sectors equally. Certain sectors were thriving despite the pandemic. Dollarama, for example, saw a surge in activity and avoided any lockdown during the height of the crisis. Technology stocks like Shopify and Absolute Software also saw greater demand. 

Investors retreated to these essential stocks during the crisis. However, this flight to safety has pushed valuations to unbelievable levels. Meanwhile, valuations for real estate and restaurant stocks have dropped below reasonable levels.

Brick-and-mortar companies are being underpriced while technology companies are being overpriced. 

Any dislocation between investor expectations in the months ahead could trigger a stock market crash. 

Another stock market crash

Another bear market — an over 20% drop in stock prices, can’t be ruled out. In fact, even a 20% drop may not be enough to make some stocks fairly valued. 

If you’re worried about the economic recovery being slower than expected or a second wave of coronavirus cases in 2020, you should secure yourself financially. Invest in hard assets such as gold or place a portion of your portfolio in cash to mitigate the downside.

More cash and gold in your portfolio also allows you to buy assets cheaply if another stock market crash is triggered. 

Bottom line

Stocks have quickly rebounded from their March lows. Now, the stock market and certain sectors such as healthcare and technology could be priced to perfection.

Unexpected risks are not being priced into the market. Another stock market crash can’t be ruled out. Stay prepared by moving part of your portfolio to gold and cash. 

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Vishesh Raisinghani has no position in any of the stocks mentioned. Tom Gardner owns shares of Shopify. The Motley Fool owns shares of and recommends Shopify and Shopify.

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