Why I Think We’re Headed Back to More Normal Valuations

Maybe, just maybe, the stock market is starting to return to normal…

I know that’s the last thing those who know my work expect me to say.

So don’t misunderstand what I mean by “return to normal.” I’m still bearish on the overall stock market.

I still feel like a drawdown – even a market crash – is within sight. That’s what I mean by “return to normal.” And I promise, as painful as it would be for those who aren’t prepared for it, a bear market in stocks would be a very good thing in the long run.

The more investors grow accustomed to high valuations getting higher, the more distorted their thinking becomes… the more inclined they’ll be to engage in dangerous speculations… and the worse they’ll be blindsided when reality reasserts itself (as it always has and always will).

So when I say, “Maybe the stock market is starting to return to normal,” I mean that today’s valuations are way above normal – and maybe that’s all about to change over the next several weeks and months.

Here’s one reason why I think we’re headed back to more normal valuations…

Some of the most egregious signs of speculative frenzy appear to be behind us.

I’m talking first and foremost about “meme stocks.” The most popular one today is AMC Entertainment (AMC).

The stock’s 52-week low is $1.91, reached on January 5 of this year. Its 52-week high is $72.62, also using intraday prices, achieved on June 2 of this year. That’s right… It became a 38-bagger, a 3,700% winner, in slightly less than five months.

Today, a little more than two months after becoming a 38-bagger, AMC is trading around $37, a drop of nearly 50%. Shares are still egregiously overvalued, but the fact that they’re down nearly 50% is reassuring to me.

It could be a sign that the market feels like it sucked in enough losers and is ready to show them what happens when you have no idea what you’re doing.

The other famous meme stock, GameStop (GME), looks about the same. Its 52-week low, hit on August 20, 2020, is $4.51. And its 52-week high, reached on January 28, is $483. That’s more than a 100-bagger from bottom to top. It’s trading near $160 today, down nearly 70%.

And now, short sellers – who got burned in the speculative mania – are wading back into the fray…

I noticed that, about a month ago, AMC canceled plans to sell as many as 25 million new shares for proceeds of approximately $1 billion. The Financial Times reported that AMC appeared “to have hit the limit of what its existing shareholders will tolerate.”

Then, a report came out that said Odey Asset Management, a fairly well-known hedge fund, had taken a short position in AMC. In a letter to investors, Odey manager James Hanbury told clients that retail investors’ frenzied meme stock speculations were among several factors that have “created major distortions” leading to “compelling short opportunities.”

You might recall that the meme stocks soared so high so quickly because retail-investor buying prompted large hedge funds to buy, so they could limit their rapidly growing losses in large short positions.

With $4.1 billion under management, Odey is not enormous by today’s standards. But the fact its team is willing to step back into the fray tells me perhaps they believe the worst craziness is finally behind us now… that the meme stocks will trade more in line with their business prospects.

Not only that, but famous short seller Jim Chanos said last Tuesday that he has a bet against the stock.

AMC owns movie theaters and has $11 billion in debt. GME owns stores that sell old video-game DVDs. Both businesses have been in decline for a decade or more.

These stocks traded in the ballpark of 0.1 times sales before all the meme-stock nonsense. Today, AMC is around 11 times sales, GME around 2. A return to pre-nonsense levels would send both stocks down to roughly 95% or so below current levels, and closer to 98% or 99% below their meme-era highs.

In this case, I see that the market is getting back to its long-term job of assigning asset prices that reflect the fundamentals…

And I see this as one of the signs that a downturn is on the horizon.

U.S. stocks are bumping against their most expensive valuations in history, according to all the metrics that have correlated most closely with historical returns…

For example, the price-to-sales (P/S) ratio of the benchmark S&P 500 Index has negatively correlated with subsequent 10- and 12-year average annual returns about 90% of the time since 1928.

In other words, when valuations have been high, the returns that follow have been low.

Today, the P/S ratio of the S&P 500 sits at a little more than 3, meaning share prices of the United States’ biggest companies are more than three times higher than their sales. That might sound like a lot, and it is…

The P/S ratio of the S&P 500 now is roughly 35% higher than it was at the peak of the dot-com bubble.

I could cite plenty of other metrics, but you get the picture. I still expect that at some point, we’ll see a drop in the S&P 500 in line with previous all-time high valuations, somewhere between 50% and 65%… and an even bigger drop for many individual stocks.

What should you do? I can answer that question…

Prepare, don’t predict. That means holding stocks, bonds, plenty of cash, silver, gold, and maybe a little bitcoin if you’re comfortable with it.

Ben Graham, the father of value investing, said the stock market is a voting machine in the short term and a weighing machine in the long term. So maybe the voting period on meme stocks – and soon enough, the U.S. stock market – is over.

Let the weighing begin…

Good investing,

Dan Ferris

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Source: Daily Wealth