Stocks Are Still Very Overvalued – Here’s How to Profit Anyway

Investing Strategies

There are times when avoiding losses is far more important than looking for gains.

As the debate continues between what the Federal Reserve says it will do and what the market thinks the Federal Reserve will do, there is one inescapable conclusion we must consider: no matter how you look at the world, and regardless of your expectations for the economy and the Fed, stocks are not cheap at current levels.

Let’s look at the numbers, and where to find the real bargains…

Financial bubble about to burst

According to the latest issue of Barron’s current issue, the price-to-earnings ratio (P/E) of the S&P 500 is 22.

Noted economist Ed Yardeni uses the old-fashioned rule of 20 to reverse-engineer a projected price-to-earnings ratio of just 13.5 based on current conditions. The Rule states that the result of the market PE + CPI growth rate must be under 20 for stocks to be undervalued. Currently, the rule of 20 calculation is 28.76. Multiplying 13.5 times the most optimistic forecast for 2023 earnings gives us an index target of just 3,307.

My own valuation analysis gives me a fair value for the S&P 500 of around 3,100-3,200.

The index trades at 4,136 as I write this.

We could all be wrong. The Fed could engineer a soft landing that pushes inflation back under 2% without causing a recession.

Interest rates could come down despite robust economic growth, and unprofitable tech stocks can resume their journey to infinity and beyond based on expectations of a brave new world.

It has never worked that way before during periods of high inflation, but it could happen.

Right now, I continue to find bargains in corners of the market that most people avoid, like small banks and discounted closed-end funds (for more on this, see below), but the broad market is beyond fully priced.

Piling back into the unprofitable companies that rallied in 2021 and the first half of 2022 will likely lead to disaster.

The hot-stocks-with-no-profits game is something Wall Street loves to play. Of course, it always ends badly, but just as the Washington Generals have always optimistically taken the court against the Harlem Globetrotters, Wall Street and retail investors cannot help playing the game.

Wall Street plays because the game produces fat fees and commissions.

Retail investors play because they’ve been sold some get-rich-quick schemes on these world-changing companies.

Consider Lucid Group (LCID), the electric vehicle (EV) maker. The company went public in a special purpose acquisition company (SPAC) merger back in 2021. Because electric vehicles were going to change the world forever, the stock soared from $10 to over $50.

Lucid has a great story. The top executives used to work for Tesla Inc. (TSLA). It manufactures a cool-looking car. The Saudis are involved and own over a billion shares of stock.

Last month the Kingdom of Saudi Arabia bought more stock to prop up Lucid’s faltering finances, sparking speculation that the Saudis would buy out the rest of the company.

They might buy Lucid, but if they do buy an unprofitable company, with just $376 million of sales, for more than $13 billion, it will go down as one of the dumbest purchases of all time.

Lucid is competing against Tesla and all the leading auto manufacturers to be a winner in the EV market. Unfortunately, the average selling price of a Lucid electric vehicle is over $100,000, making their task fairly difficult.

The odds of a Saudi takeover are a coin flip at best.

Keep in mind that we are talking about Saudi Arabia. When someone loses money and royalty screams for the guilty party’s head, it is not always metaphorical.

Cybersecurity is another area of the market that has attracted a lot of attention, as it should. It will be a massive business for as long as there are criminals.

That would suggest forever.

Leading cybersecurity stocks like Zscaler Inc. (ZS) and Cloudflare Inc. (NET) have attracted a lot of speculative attention based on the quality of their cybersecurity offerings.

Both companies have strong products. The problem is that the prices of the stocks are ridiculous, even given the potential for high growth.

Zscaler is still losing money and trades for more than 15 times revenue. Analysts hope the company makes a profit next year. If it matches Wall Street’s expectations, the share will have a bargain basement P/E of just 445.

Cloudflare fetches 20 times its sales and trades hands at 404 times what the Street hopes it will earn next year.

There are no numbers I can plug into any reasonable valuation model to match the current price of either stock.

When people tell me how great the companies are and how bright the future is for these leading cybersecurity firms, I agree with them and point out that the same could have been said of Cisco Systems (CSCO) back in 2000. Twenty-four years later, if the stock gains another 30 points or so, investors who bought CSCO back then will finally be even.

Sometimes the key to making money is not to lose it chasing hopes and dreams.

Math and reality will make you a lot more money over time.