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You Better Pay Attention

Written by Briton Ryle
Posted July 24, 2017 at 5:09PM

I don't even know what to say about it anymore. Stock prices are in la-la land, humming along like a rush-hour bicyclist with headphones on. Sure, a little Led Zeppelin is great, but the roar of traffic coming up behind you is completely drowned out. The perma-bulls will be lucky to get the license plate number of the truck that hits them. 

I can't tell you for certain which truck it will be (though I have some ideas). But pretty much everything I look at tells me the truck is going to win this one. 

Stocks are pricing the very best of times. Netflix (NASDAQ: NFLX) is currently valued at $80 billion. It has a forward price-to-earnings (P/E) ratio of 94. Buy the company, and it will take you 94 years to pay off it off with the profits the company generates.

Look, Netflix is a great company. I love the service. But I have no problem saying you should not buy the stock at ~$187 a share. The odds are overwhelming that you will lose money. ("Hey hey mama said the way you move...")

Bubble-stock barker Elon Musk recently came right out and told investors that his company's stock is overvalued. He said Tesla's stock price was "higher than we... deserve." But Tesla is up over $10 today. I guess it's because Musk has said Tesla will pump out 20,000 of the new bargain-priced Tesla 3 units a month. This despite the fact that Tesla only sold 76,000 of the more expensive Model S last year — and lost money on every single one of them. ("Well that light in your eye keeps shining, like a star that can't wait for the night...")

Comparisons between Tesla and Ford are ridiculous. 76K cars for Tesla, 3 million for Ford. $51 billion in levered free cash flow for Ford, $675 million (that's million, with an "m") for Tesla. Ford pays a 5% dividend, Tesla pays... bwahahaha... I can't even type it without laughing.

Investor verdict: Tesla is worth more than Ford. By $10 billion. Wow.

Despite falling revenue and earnings for the last five years, Caterpillar (NYSE: CAT) got an upgrade today on "the unfolding cyclical recovery" of industrial companies. Caterpillar is very much an emerging market play, even though emerging markets are much less dependent on natural resources than they were just a few years ago. The stock is about 5% from record highs. ("We'll drive our ships to new lands...")

Complacency and Volatility

Last Friday, the Volatility Index (VIX) closed at a new record low. I've written about this before, if you want a little refresher.

Investors simply do not see risk anywhere. For instance, high-yield emerging market debt is virtually nonexistent. One emerging market bond ETF has doubled in size so far this year. The average yield in the ETF is 4.7%. That's not a lot of reward for taking on the risk of emerging markets.

Because we all know when emerging markets turn bad, it happens fast. And the amount of money emerging markets have raised by selling dollar-denominated bonds is scary. When a foreign company borrows in dollars, it has to convert the local currency into dollars to pay it back. If the dollar is falling in value, then it works great. 

But I find it easy to imagine that the U.S. dollar could rally, because, um, did anyone notice the Fed is hiking interest rates? Still, demand is massive for emerging market bonds. But it's not because growth looks so good. It's just yield. Yields are so low across the board that investors are happy to take on the risk. Makes me wonder what investors are thinking. ("I got a woman, stay drunk all the time...")

The irony of this is that risk is highest exactly when investors don't see any risk. The Volatility Index was at lows right before the dot-com bubble popped and right before the subprime bubble popped.

In both cases, consumer confidence was very high. People felt the economic expansion really was different this time. And it feels that way again. People see nothing but blue skies for a wide range of companies: Apple, Google, Facebook, Nvidia, Wal-Mart, Amazon, McDonald's, Domino's Pizza...

That's how it is when stocks are at record highs.

Interest Rates, GDP, and Earnings

So, the IMF lowered U.S. GDP growth again, from 2.3% to 2.1%. Seems like I remember growth was expected to be at least 2.7% at the start of this year. Weird, growth isn't as good as expected, but you wouldn't know it looking at the stock market. Investors continue to anticipate a fantastic stretch for earnings. 

And while it's true that first-quarter earnings were really good, we have to be at least a little concerned about earnings going forward. Second-quarter earnings just started, and expectations are that they will grow around 7% for the S&P 500.

But about half of that growth is coming from energy companies, thanks to marginally higher oil prices. Ignore energy companies, and earnings growth should hit 4%. Does that justify a forward P/E of 19 for the S&P 500?

Did you know that the next Fed decision on interest rates is coming this Wednesday? And did you know that Fed Chief Janet Yellen is planning to start reducing its balance sheet in September?

This balance sheet thing is a big deal. If the Fed is selling bonds, that could easily push prices down — and interest rates up. Higher rates make dollars more expensive for emerging market companies, they make U.S. government debt more expensive, they make mortgage loans more expensive, and so on and so on. ("And she's buying a stairway to heaven...")

I really don't know what's gonna send this market into a correction. My bet is emerging markets. I think we get a currency crisis or two when the dollar strengthens on higher rates.

But it doesn't really matter where it starts. Now is the time to stay on your toes, keep your eyeballs peeled, as my dad used to day. Because when this bull market breaks — and it will — investors who aren't paying attention will get run over. ("If it keeps on raining, levees going to break... when the levee breaks, got no place to stay.")

Until next time,

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Briton Ryle

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An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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