The reality behind the current rally on Wall Street is that stocks are overpriced. The problem is that most stocks have just priced themselves way ahead of their earnings. In fact, the current trend is to price stocks not based on their current price-to-earnings ratio, but based on future price-to-earnings ratio.
This kind of thinking is reminiscent of the first Dot Com crash of 2000. You remember those heady days, right? Those were the days when stock analysts would price internet companies that weren’t making any money based on what they could make in the future. In other words, the stock market was running on fumes. It was running on hype. It was being pushed forward by a dream. Not surprisingly, the party ended and all those stocks crashed back to earth or disappeared entirely as the companies behind them folded.
I suspect that a lot of that will be happening this time around. However, the danger is spread out not just from highly speculative social media stocks like Twitter, but biotechnology stocks. More surprisingly, otherwise solid companies will also be hit because they have too much debt. Thanks to the red-hot equities market, a lot of companies have been raising tons of money through the debt market and investors can’t get enough of this debt because these are solid companies. Put all these factors together and it is not a surprise if the stock market goes through a prolonged correction.
The reality that Wall Street cannot escape is that the stock market does not set what goes on in Main Street. It is the other way around. In other words, stocks have to be based on reality. Unfortunately, we have been riding sky-high valuations for a long time. In other words, we have been in fantasy land for a long time, and it may be time for those sky-high dreams to come back to earth.
