3 Keys To Identifying Stock Market Madness

3 Keys To Identifying Stock Market Madness

Like a drunk driver who’s begun to believe the speed limit no longer applies, the stock market can continue onward to higher highs until the inevitable smash-up. Similar to the effects of inebriation, analysts and those who rely on them will continue to come up with reasons to keep buying.

Some will invoke hot concepts like the power of artificial intelligence. Others will drop the “innovative,” “visionary,” and “disruptor” themes that have driven markets so fiercely since the last crash. Whatever stimulates potential investors to keep coming back, relentlessly, for even more.

It’s impossible to call market tops much less exact market tops. If you’re feeling great about chasing the 5 or 6 growth stocks on fire right now, here are 3 measures you might want to consider before you hit the “buy me more” button again. None of these are perfect — it’s more like a “head’s up” when you get serious about sobriety again.

Price to earnings ratio.

This classic metric answers the question “how much in earnings do I receive based on the price I am paying?” It’s the most basic of valuation measures and the beginning point for the Benjamin Graham/Warren Buffett style analysis of fundamentals. Note that “expected earnings” play no part.

The idea is to start with what exists on the books now and to ignore narratives about next year or 5 years from now. It’s a “let’s keep our feet on the ground” concept. The mean price of the Shiller p/e is 16.75 — right now the ratio sits at 31.68. We are up there where it seldom goes, historically.

Thanks to multipl.com for the use of this chart and the next one…

Price to book value ratio.

This is the metric that answers the question “what is the value of everything on the company’s books to the price I am paying?” Note that the ratio gives up information about what exists now, not what might exist in the future. So, it’s similar in that way to the price/earnings ratio.

You can see on the chart that the price-to-book is at the highest level it’s been since coming off of the Great Recession of 2008. It hasn’t yet reached the peak of the “dot.com” boom of late 1999/early 2000, but we’re higher than 2002 levels already.

Odd divergences between “the story” and underlying metrics.

The “story” is that the stocks rallied spectacularly off the March, 2020 lows. The reality, as displayed by this metric, is that fewer and fewer stocks are making new highs. What’s happening is that most of the big money is going into 5 or 6 hot tech names and the rest of the market gets the scraps.

Ultimately this disconnect between the handful of favorites and everything else is unhealthy. Typically — not always — but typically, such a divergence has a way of ending poorly for everybody involved. To stay bullish, the market needs to show a wider group of new 52-week highs.

Thanks to macrocharts.blog for the use of the chart.

Those are the metrics to keep an eye on when you begin to get the urge to load up on “compelling” initial public offerings of hyper-growth stocks or whatever’s being offered by anyone who claims “visionary” or “disruptor” in their CEO bio. If you find yourself fascinated by whatever the story is, come back to the metrics.

They’re not perfect — nothing is — but they can tend to keep you out of big trouble when the madness takes hold.

Stats courtesy of FinViz.com.

I do not hold positions in these investments. No recommendations are made one way or the other.  If you’re an investor, you’d want to look much deeper into each of these situations. You can lose money trading or investing in stocks and other instruments. Always do your own independent research, due diligence and seek professional advice from a licensed investment advisor.

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