The Stock Market is Truly Priced for Perfection...Should it be???
Investors are EXTREMELY complacent right now, so the risks are VERY high.
The stock market pricing-in that the war in Iran will not escalate further. However, it is ALSO pricing-in the kind of economic growth going forward…as well as the kind of earnings growth going forward…which is unlikely to come to fruition. Therefore, it is “priced for perfection.”…….Since “perfection” is rarely achieved, investors should not be as complacent as they are right now.
To say that the reaction in the marketplace to the escalation in the war in Iran has been a benign one so far is the understatement of the century. Don’t get us wrong, there are definitely several reasons to think that this development will not have an outsized negative impact on the global economy. The most important one surrounds the idea that Iran cannot respond in a significant way without doing more harm to themselves. If they close the Strait of Hormuz, they alienate their biggest benefactor (China)…and if they respond with a large direct military attack on US assets or terrorist attacks within US assets…they risk obliteration.
Another one of the key reasons whey the markets are not reacting much at all to this direct intervention by the US has to do with the thought that there will be a regime change in Iran. That might not create the kind of outcome that will bring harmony to the Middle East, but if it ends the country’s quest to become a nuclear power, it would still be a very positive outcome to this war…and it would give Israel an historic victory. Thus, it’s certainly a genuine reason to think the war in Iran will not have an outsized negative impact on the markets.
In other words, the stock market is pricing-in the thought that Iran will not respond in a significant way to the direct intervention of the US into this war. Again, there are some good reasons to think that this will be the case. However, it is likewise true that the stock market is ALSO pricing-in the idea that the economy is going to grow in a way that is much stronger than the consensus is looking for (and much stronger than the data is telling us right now). It is also pricing-in that the decline in earnings estimates that we’ve seen for almost a year now…will reverse itself in a historic fashion. In fact, if you look at history, the stock market is pricing-in that earnings will increase by 20%-30% in both 2025 and 2026…and not the single digits growth which is presently expected for 2025…and low-double digits that the consensus is looking for right now 2026.
Therefore, the stock market is priced for perfection…on both the fundamental side of things…as well as the geopolitical side of things. Given that “perfection” is rarely achieved, this means that the risks are EXTREMELY high right now for those who are fully invested (in terms of individual investors)…or aggressively invested (for professional investors who have remain fully invested). With this in mind, we strongly believe that those individual investors who are fully invested in the stock market should raise at least SOME cash…and that the pros who are aggressively invested should become at least A LITTLE BIT more defensive.
Whenever the market becomes as expensive as it is today (22x forward earnings, 3x sales, 5x book value), it has always experienced a significant decline…eventually. With level of economic growth slowing…earnings forecasts falling…and geopolitical risks rising…it’s not a stretch to think we’ll see another one of those meaningful declines before the year is over.
Again, we understand why many people believe that a serious response from Iran might not be a probable outcome. However, we remember what took place in 2020…when almost everybody said that the odds that the pandemic would turn into a major problem were extremely low as well. The market was similarly expensive at that time…and therefore, when it turned out the consensus was wrong about this issue in early 2020, the stock market crashed 35% in just one month.
The odds we’ll experience a similar “surprise” might be somewhat low, but they’re still higher than usual. More importantly, since there are plenty of other (more likely) developments which could cause the rally in the stock market to see a meaningful reversal (albeit a smaller and slower one than we saw in early 2020), we believe that investors should be a lot less complacent than they are today.
Our comment has been shorter than usual this morning…and we have not included any charts. However, after thinking about many, many different ways to convey our stance on the markets right now, we believe this shorter-than-usual comment lays it out quiet nicely (even though we’ve done so in a very quick and simple manner).