Analyst Says Financial Markets Are “Fundamentally Broken”

Some folks say that the markets don’t lie, but there are times when it’s hard to overlook the dislocations in asset prices. For Greenlight Capital’s David Einhorn, the disconnect between prices and actual values is wide and only getting wider.

“I view the markets as fundamentally broken,” Einhorn unequivocally stated. “Passive investors have no opinion about value. They’re going to assume everybody else has done the work,” he added.

Certainly, being a passive investor shouldn’t mean letting others do all of the research and due diligence. That approach is tantamount to allowing other people to control your financial future.

I doubt that Greenlight Capital would green-light such an approach, and Einhorn clearly wants uninformed investors to wake up and smell the coffee. Valuations of major U.S. stock market indexes are getting rich, and a broad-market contraction could take many retirees and other investors by surprise.

It’s not an indictment, but only a warning to shareholders who take passivity to an extreme level. “The passive people, they don’t care what the value is,” Einhorn admonished recently.

Suffice it to say that a whole lot of optimism has already been baked into the cake as the S&P 500 and NASDAQ continue to test all-time highs. Now, large-cap companies have to justify their lofty valuations or else risk a painful reckoning for the shareholders.

Courtesy: Bloomberg, @MichaelMOTTCM

If you doubt that valuations are high, feel free to pick any traditional metric: price-to-earnings ratio, price-to-sales ratio, or price-to-book ratio. No matter how you slice it, large-cap stock indexes are fully valued on a historical basis.

Moreover, don’t assume that the problem will get better before it gets worse. “It’s continuing to get worse,” the hedge fund manager told Picker. “We are in a secular destruction of the professional asset management community,” Einhorn explains.

Einhorn further observes that continue to “beat and raise” earnings expectations again, leading to complacency in the markets and high price-to-earnings ratios. He didn’t mention NVIDIA by name, but NVIDIA may be considered a textbook example of a mega-cap company with sky-high earnings expectations.

I’m pointing to NVIDIA because reportedly, the company is using “mark-to-market accounting” – in other words, using future expected income gains in their current financial forms. Could there be a sell-the-news event if NVIDIA fails to live up to its own assumptions?

It’s entirely possible, but for the time being, mega-cap technology stocks are the darlings of the market while deep-value stocks routinely get overlooked. As Research Affiliates Chairman Rob Arnott put it, “Value stocks have been getting cheaper and cheaper relative to their underlying fundamentals, while growth stocks have been commanding richer and richer valuation multiples.”

Courtesy: BarChart

In times like this, it’s easy to disregard the warnings and just keep buying passively. However, the Super Micro Computer (SMCI) chart should serve as a reminder of what can happen when investors buy hand over fist during a hype cycle.

Currently, the hype cycle revolves around artificial intelligence or AI. There’s no denying that AI will change the world, but passive income investors are deeply piled into AI-focused stocks whether they know it or not.

And, the markets have already priced in their ultra-optimistic beliefs about AI’s future growth. Thus, Einhorn’s remarks should prompt uninformed investors to reconsider their portfolio holdings and make the necessary adjustments.

Yet, few of them will truly heed Einhorn’s warnings and take action before it’s too late. Thankfully, you still have a chance to prepare for all possible outcomes – including the “secular destruction” that Einhorn is bracing for.