Billionaire Investor David Einhorn Has a Big Warning for Stock Investors

David Einhorn is one of the most influential hedge fund managers in the world. His investment strategy involves buying undervalued equities and simultaneously shorting overvalued stocks while maintaining exposure to major economic trends. That has enabled his fund, Greenlight Capital, to produce returns that look meaningfully different from the overall market in any given year.

One of Einhorn's best-known trades is shorting Lehman Brothers in 2007. Unfortunately, the fund hasn't been nearly as successful since that short sale paid off.

It has mostly underperformed the S&P 500 since then, with a lone standout performance coming amid the 2022 bear market. But modest performance in bull markets with strong outperformance amid bear markets has enabled Greenlight Capital to produce total average annual returns of 12.7% since its founding in 1996, outpacing the S&P 500's yearly average 10.2% return in that period.

So, Einhorn is worth paying attention to, especially when he talks about a potential market downturn. In his most recent letter to investors, he issued a major warning that could lead his fund to another period of outperformance.

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Stocks are reaching dot-com bubble levels

Einhorn has been warning of rising valuations in the market for a couple of years. His letter to investors ramps up that warning:

We believe that the U.S. equity market is the most expensive we've seen since we began managing money, and arguably in the history of the United States. It isn't just our skepticism about AI stocks; speculative behavior among retail investors is palpable. ... From a long-term perspective, we still believe that this is not a great time to have a lot of equity exposure.

Greenlight opened its doors in 1996 in the midst of the dot-com bubble. Many unprofitable stocks traded for billions of dollars at the time. The S&P 500 forward price-to-earnings (P/E) ratio climbed above 24, and the CAPE ratio, which is designed to adjust returns to account for inflation, climbed above 44 in late 1999. Today, the S&P 500 trades for a forward P/E is about 22 and its CAPE ratio exceeds 40 -- both very high levels historically. When these ratios are this elevated, lower market returns tend to follow.

Meanwhile, the Buffett Indicator, which measures the total stock market cap as a ratio of gross domestic product, peaked at 144% in March 2000 (70% to 80% is considered favorable) just as the dot-com bubble peaked. The Buffett Indicator now stands about about 224%. Buffett says the figure is the single best sign of an overvalued market.

The big fast-growing artificial intelligence (AI) stocks that make up the bulk of the S&P 500 are a big reason for the higher valuations. With expectations for those stocks to increase earnings quickly during the next few years, they have pulled up the valuation of the entire market.

But Einhorn believes the capital spending from many of those companies, amounting to hundreds of billions of dollars per year, could lead to immense capital destruction. It's almost guaranteed that AI companies will overbuild capacity in an attempt to stay ahead of the competition. That pattern has repeated itself in every major technological boom in history, including the dot-com bubble.

Einhorn also calls out speculation from retail investors. He has his concerns about the big AI stocks, but the valuations of many smaller companies, even those unrelated to AI, have also climbed. And those valuations could be even less reasonable.

It's a concern renowned investment manager Howard Marks has also voiced in his memos at Oaktree Capital Management, as many of these stocks are rising on speculation that AI will eventually improve productivity and profits for those businesses.

Should investors sell everything?

Einhorn's assertion that "this is not a great time to have a lot of equity exposure" needs some context. He runs a hedge fund, which is designed to produce returns that differ from the overall market.

Most investors will do just fine if they simply match the market. Investing in a simple, broad-based index fund, even if you think stocks are overvalued right now, isn't an irrational strategy. Einhorn felt stocks were overvalued for a couple of years now, and yet they've proved extremely resilient.

As the legendary investor Peter Lynch has said, "Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves."

That said, for investors who want to take a more active approach, there are still values to be found in the market, despite its overall high valuation. Einhorn highlighted several new Greenlight purchases in his letter: natural gas specialist Antero Resources, footwear distributor Deckers Outdoor, and payments processor Global Payments, among others.

With many investors' speculative behavior in the market, right now might be a great time to focus on value stocks. Finding individual stocks where the market underestimates their potential and offers a discount price is a great way to bolster your portfolio and set it up to participate in the upside while maintaining downside protection. Value stock index funds can do the job, too, but they might also include some lower-quality stocks that deserve a low valuation.

Einhorn has a great track record of positioning his fund well for a bear market. But his track record also includes preparing for bear markets that never materialize and making big bearish bets that don't work out. Investors should be mentally and financially prepared for a pullback in stock prices, but not at the expense of missing out on the potential for continued gains.

Adam Levy has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Deckers Outdoor. The Motley Fool has a disclosure policy.