The Short Squeeze: Another Failed Reality Check For The Markets

With last week’s historic short squeeze by retail traders appearing to taper off, the wave of buying euphoria that had prevailed in early January is now returning into the markets.

Analysts in the media continue to discuss the “strong” gains claimed by the market in 2021, using the familiar yardsticks of the S&P 500, Nasdaq Composite, and others.

For many years at Dohmen Capital Research, we have highlighted the dangers of placing too much emphasis on the widely-watched large-cap stock indices. Most investors don’t realize just how easy it is for institutions to manipulate the prices of a few key stocks to give the public the impression that the stock market is much stronger than it is.

The S&P 500, which is primarily driven by the performance of only a dozen or so mega-cap stocks, has gained nearly 107% since the beginning of 2014, an impressive figure. The VALUG, however, which weighs over 1600 stocks equally, and in our view is much more representative of the market’s true performance, only gained a measly 21% over the same period.

On the chart below, we can see that the VALUG, after recently breaking above its 2018 highs, has since turned lower:

Because the VALUG is comprised of many more stocks and gives smaller companies and larger companies equal weighting, it is also tied more directly with economic conditions than the S&P 500.

In fact, the VALUG’s growth is much closer to the U.S.’s real GDP growth of around 2% per year since 2014. It indicates that the vast divergence between the S&P 500 and VALUG above is the result of inflated valuations in the popular larger cap stocks, not earnings growth.

When the impact of the pandemic eventually passes and the economy returns to normal, what will investors do when companies are unable to justify their lofty valuations with better profits?

Here is a great chart that shows how overextended stocks are, versus the underlying reality: It shows that the S&P 500 growth (orange line) is now 8x times GDP growth (purple line) and 3x corporate sales growth (blue line). Economists always tell us that the stock market reflects economic growth. That’s precisely why we don’t listen to economists (chart via Real Investment Advice):

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Our elite group of members were able to position their own investments ahead of these major market moves to the upside and ahead of the big declines. In our award-winning Wellington Letter, we ...

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