- Stocks continue to inch upwards as an economic reopening looms.
- But with valuations extended, Phil Toews warns a meaningful sell-off is likely due.
- He said a 30% drop or more in the S&P 500 is “highly probable” in the “not too distant future.”
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We’re living through a fascinating moment in financial history, according to Phil Toews.
Toews, who is the CEO and a portfolio manager at Toews Asset Management, which manages $2.2 billion in assets, told Insider on Thursday that investors have become blind to the insanity of some asset valuations, which resemble those of tulipmania in the Netherlands in the 1600s, when tulip bulbs sold for what would today be hundreds of thousands of dollars.
“When you look back at Holland, you’re like, ‘That was so crazy, how could they pay that much for a tulip bulb. But when it’s happening in real time, it’s hard to recognize,” said Toews, who is also and the founder of the Behavioral Investing Institute. “So people think, ‘Well that’s perfectly rational to pay $600,000 for a pop-tart meme.'”
“We’re living in history through something that’s as bizarre as tulip mania. And everybody’s just like, ‘It’s fine,'” he added.
More broadly, indicators like total market capitalization-to-GDP (also known as the Warren Buffett indicator) and price-to-sales ratios are at historically astronomical heights.
But the upward trend can’t go on forever, and a “significant downturn” in stocks – which he defined as a pullback of 30% or more – is “highly probable” in the “not too distant future.”
“Ultimately, this market will fail, and potentially spectacularly fail, primarily because of valuations,” Toews said.
Timing is a key part of Toews’ thought process. He said he expects the downturn would happen sometime in the next 12-24 months because the economy first has to get on completely solid footing. When this happens, the Fed would no longer be willing to keep the floor under markets that investors are currently relying on, he said.
One signal that a crash in stocks could be close, Toews said, is a consistent period of high volatility – rises and falls of 3% or more in single days. This took place in 1999 before the dot-com bubble burst, he pointed out.
Toews also said that asset inflation in areas like cryptocurrencies will contribute to the magnitude of the sell-off in stocks because when the crypto bubble pops, people will have lost the “real wealth” they put into it.
On cryptocurrencies, Toews is bearish because he argues they lack real value, and their returns come solely from “massive speculation.” He added that big players like investment banks stepping into the space will only grow the bubble larger.
Toews’ views in context
Stock market valuations are indeed a widespread concern on Wall Street. With anticipatory investors already pricing in much of the economic recovery, the median estimate for the S&P 500‘s year-end target from top investment banks is 4,150, slightly below current levels.
Head strategists at Bank of America, Wells Fargo, Citigroup, Morgan Stanley, and Stifel all have year-end price targets of 3,900 or lower, though they see opportunities in individual names and market sectors.
But none seem to see a sell-off of 30% or more in the months ahead – it would be hard to do so with the gargantuan economic growth that’s expected this year. Also, Wall Street analysts severely underestimated earnings growth in the first quarter, as 86% of S&P 500 companies have reported better-than-expected profits. That’s on pace for a record according to FactSet data that goes back to 2008, and a reminder that upside surprises can always happen.
However, Toews’ views are a little bit longer of a timeline. What the market will look like a year from now is a mystery.
Investor Insights’ Gautam Khanna said on Friday that he expects the Federal Reserve to announce later this year that they will begin tapering their bond buying in 2022. When the central bank signaled they would do this after the global financial crisis, Treasury yields spiked. If they do so again, stocks – especially growth names – could suffer.
Earlier this year, investors were spooked when 10-year Treasury yields rose 83 basis points over the course of three months.
Inflation could also present a hurdle to stocks going forward, with an economy flush with cash and the Fed saying they’re going to take a hands-off approach.
For now, though, stocks continue to inch upwards and volatility is low, a sign of a benign market, according to Toews. But with valuations where they are and the speculative mood in markets at the moment, Toews’ estimation that a meaningful decline likely lies ahead could be worth keeping in mind as the next stages of the recovery unfold.