The term “stock market melt-up” is buzzing across media outlets.
Some experts are thrilled, while others warn of impending disaster.
Indeed, the S&P 500 has surged an impressive 40% since October 2023.
This aggressive uptrend is drawing comparisons to famous melt-ups of 1999 and 1929.
Since 1927, we’ve only seen 15 instances of 40% gains within a year.
That’s 15 times in 95 years.
The key question now is: Can these returns be sustained, or are we headed for a crash?
While the 1929 and 1999 melt-ups ended in crashes, history shows that’s not always the case.
Some melt-ups marked the beginning of strong, prolonged uptrends.
Today’s Market: Expensive Territory
One concerning aspect today is the market valuations that are reaching extreme levels.
The Shiller PE ratio, which measures market expensiveness, stands at 37 – one of the highest in history.
For long-term investors in the stock market, these high valuations are very concerning because it usually means that stock market returns over the next 10 years are going to be low.
We can prove that out…
What High Valuations Mean for Investors
Historically, the market has delivered anywhere from 300% gains to 50% losses over a decade.
For instance, after periods like 1929 and 2000, the market saw huge declines over the following 10 years.
Typically, high valuations lead to lower 10-year returns.
When we add in the Shiller P/E ratio, but invert the chart, it’s clear that valuations predict long-term returns.
Right now, valuations suggests that 10-year market returns are going to be very low. Potentially just as low as in 1999 and 1929.
This means that a “buy and hold” strategy is unlikely to work well.
Stock selection and risk management will be even more important over the next couple of years.
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The Profitability Factor
But, despite high valuations, there’s an argument for continued growth:
- S&P 500 companies are more profitable than ever
- Profit margins expanded from 6-7% to 10% since the 1980s
- Tech boom has significantly boosted corporate efficiency
This increased profitability partly explains today’s high valuations.
A New Normal for Valuations?
Given all this, the long-term average PE ratio of 15 might be outdated.
It doesn’t really makes sense for the stock market to be priced today in 2024 to the same level as in 1973.
A new average around 20 could reflect increased productivity and profit margins.
But current valuations are near 40, which is still 2x that level.
This is hard to justify…
After all, corporate profit margins have expanded by 30%. They haven’t doubled.
The other problem with these valuations is that we don’t know if corporate profit margins will remain this high.
There’s also the added risk of a recession.
Corporate profit margins tend to contract during recessions.
So, the next downturn will test the resilience of these high margins.
We expect profit margins to shrink substantially during the next recession, which should bring valuations lower.
However, until that happens, we are in one of the most profitable markets since the 1940s
Today’s market is about 20% more profitable than in 1999.
Theoretically, valuations could surpass the 1999 peak of 43.
This suggests potential for further upside in the current melt-up.
Our Strategy
While we expect a recession by January 2025 and an eventual valuation deflation, our strategy has been to not bet against the market in the past 2 years.
Despite the risks, the uptrend in the market remains intact.
We’ve used dips as opportunities to enter attractive new long trades.
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- 75 trades in 2024
- Average profit of 17.37% per trade
- Average loss of only 3.78%
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