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Where Did This Rally Come From And Can It Continue?

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We are in a medically induced global economic downturn, yet the stock market is responding as if our decade-long bull run is still underway. The Nasdaq 100 is sitting at all-time highs, and the S&P 500 flipped positive for the year. The markets have been backstopped by the Federal Reserve's unprecedentedly dovish monetary policies, but does it warrant this insane market rally?

The economically devastating COVID has given well-positioned tech companies a rare tailwind, which has driven most of this V-shaped recovery in the equity markets. What will it take to keep the stock surge rolling?

Speculation Driving The Markets

Speculation is beginning to drive the stock market as FOMO ridden retail investors search for "value" in an overheated market. Investors have been pouring enormous amounts of money into uncertain industries like energy, retail, banks, airlines, and leisure over the past month. Is it justified?

Airline ETF (JETS - Free Report) has boomed roughly 70% from mid-May, despite the extreme uncertainty about air travels revival. It could be years before passenger volume reaches pre-pandemic levels.

In the past month, Macy's (M - Free Report) is appreciated 83%, Gap (GPS - Free Report) is up 69%, and Kohl's (KSS - Free Report) drove 59% returns. These are businesses that may not even be around in the coming years with COVID-19 fanning the retail apocalypse fan.

The market is propping up ostensible "zombie" companies like Hertz (HTZ - Free Report) , which filed chapter 11 bankruptcy at the end of May. Still, investors ripped the stock up almost 1000% from its lows. A similar narrative is seen with J.C. Penney JCP shares, which ran up 500% from its lows, following its bankruptcy filings.

Retail investors have been propping up companies like Nikola (NKLA - Free Report) , a smaller (potential) competitor of Tesla (TSLA - Free Report) . NKLA has been tearing in the past month, with the past 5 trading days illustrating over 100% share price appreciation. This company is still in a conceptual phase, as it has not sold a single car yet. Still, the shares surged following the CEO's announcement that its upcoming electric vehicle release, the Badger, could be reserved by the end of June. I do not think that Nikola's current $25+ billion market cap is even close to justified.

This market speculation is a huge red flag that indicates that this market could be overvalued and is due for a pullback.

Rally's Assumptions

This market rally is extraordinarily optimistic, and its current levels assume that everything will go right in the next 52-weeks. I am not going to say that this enthusiasm is entirely misplaced, but I think that this market rally may be hitting a ceiling soon.

This unprecedented stock market rally assumes a swift and smooth economic reopening without a second wave of the virus. It assumes that there will be more monetary and fiscal stimulus and no escalation of the US-China trade dispute once both economies recover. The final assumption is that unemployment will rapidly improve as economies reopen.  

I am not as optimistic about our current situation. As state economies and businesses open, these enterprises are looking at their current staffing levels and realizing that they may not need as many employees, especially with restaurants, bars, and even retail stores opening at only partial capacity.

The equity markets are seeing a V-shaped recovery, but the economy is not. The stock market is almost entirely shrugging off the broader economic downturn, and I am extremely skeptical that we can sustain the current levels.

Stocks are driven by 3 things: earnings growth, dividend growth, and valuation expansion. 

Right now, earnings are falling, dividends are flat to down, but valuations are getting stretched like a rubber band.

The stock market is a forward-looking entity, and the historically low interest rates allow analysts to discount future earnings at a much larger value than before. Still, uncertainty about future earnings across industries is exceptionally high, and I do not believe it justifies our currently inflated stock levels.

What I Am Doing

I am not touching any equities amid this stock valuation runup. In fact, I am hedging my portfolio with SPY (SPY - Free Report) puts at varying expirations. We may still have some upward runway as retail investors unknowingly overinflated equity valuations, but this is just giving the market latitude for a more significant pullback.

Be Cautious At These Frothy Levels.

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