The stock market recently celebrated its eighth birthday on March 09, 2017. It is the second longest bull market in history, only second to the 113-month rally from October 1990 to March 2000.
- The bull market is getting stretched on the upside
- S&P 500 is overvalued both on a TTM P/E and a forward P/E basis
- Economic expansion cycle warns of a fall within the next two years
- Low volatility shows that the traders are not prepared for a fall
- The chart shows a rising wedge, which is a reversal pattern
Will the bull market see its ninth birthday without seeing a 20% correction and take over the pole position, or do we see cracks developing?
A number of experts have been caught on the wrong foot calling a top of this bull market. Therefore, we will not delve into that territory. We are not interested in making outlandish claims, which are not tradeable. We want to put our money where our mouth is, without risking our house on it.
At the current levels, we see the first signs of weakness in the markets and expect a correction to 2320 levels in the near future. What is the basis for our assumption?
High Price over Earnings Multiple
The markets have developed a myriad of P/E ratios – the trailing 12-month P/E, the forward P/E, the inflation adjusted, the Shiller P/E – that it becomes difficult to correlate all of them to take a decision.
We, for ease of simplicity, will consider both the TTM and forward P/E ratios, as these give a good idea about the pricing of the markets from a medium-term perspective. The charts have been sourced from FactSet.
The chart shows that at the current price the markets are way above the average P/E multiples. There is nothing stopping the markets from getting pricier before a correction sets in. However, with every rise, the multiples will only tick higher and narrow the gap, which started the crash in end-2007.
The stock markets are forward looking, hence, a forward P/E will be a better yardstick for valuation.
However, even if we consider the forward estimates of growth, the market seems to have priced in most of it. Here too, the index is ruling above the 5 and 10-year average forwards 12-month P/E.
With the two charts above we have been able to establish that the S&P 500 at the current levels is pricey – though not in a bubble. Such high valuations leave only a small window for surprises. With any major upheaval, the traders rush to the exit can start a deeper correction.
Economic Expansionary cycle Tells Us to be Careful
Currently, there is very little that can be pointed as being negative for the economy – strong labor markets, high confidence levels, strong earnings projections, low interest rates, etc. However, a study of business cycles done by the National Bureau of Economic Research (NBER), the official arbiter of U.S. shows that we should be careful.
Since 1945, the US economy has witnessed 12 expansionary cycles – including the present one. The average age of those cycles has been 58.4 months, while the current one will complete 96 months. There have been only two cycles that have exceeded the present one – the one from 1991-1969, which lasted 106 months and the other from 1991-2001, which holds the record as the longest one for 120 months.
Though at the first instance one can argue that there is still room for the economy to extend the cycle. Certainly! But let’s see how did those two cycles end.
The S&P 500 peaked in November 1968, a month before the expansion reached its ninth year. The S&P 500, thereafter, dropped 36% by the spring of 1970. Post the fall, the following three-year and five-year returns were an abysmal negative 1.7% and negative 6.1% respectively.
In the 1990s, the economy entered its ninth year of expansion in March 1999 and the S&P 500 celebrated it with a 17.5% return over the next twelve months. However, it was followed by a crash and dismal three-year and five-year returns of negative 10.8% and negative 12.45% respectively.
Hence, the economic expansion cycle is raising a red flag for the next two years.
Low volatility shows that market participants are lax
These days, nothing seems to worry the markets. The market participants are confident that any fall is a good buying opportunity, which has sent the VIX – the US equity fear gauge – to the lowest in a decade, though the global economic policy uncertainty is at elevated levels.
However, this is a dangerous situation when traders concentrate only on the returns, ignoring the risks involved. BofA Merrill Lynch said that the traders are piling on the inverse VIX exchange-traded products (ETPs) linked to the CBOE Volatility Index, which bets volatility to remain low for long.
“A sudden shock to U.S. equities could pressure those invested in such strategies to short cover, thus exacerbating the rise in volatility,” the bank says, as reported by Reuters.
Middle East tensions, North Korean misadventures, Chinese debt problems, central bank withdrawing stimulus – any of these can cause a scare that can increase the volatility and bring the markets down.
Risk to our analysis
The market conditions are benign for the rally to continue further. If the S&P 500 goes on to hit new lifetime highs and sustains above 2453.8 levels for three days, it can continue moving higher till the 2480-2500 levels. A market can remain overvalued for an extended period of time.
Shorting the markets is an advanced technique, which should only be used with proper stop losses. The risk on the upside is theoretically unlimited. Hence, please maintain the stop losses mentioned in the analysis and only enter the trade once the said levels are reached.
What do the Charts Forecast?
The index is rising in a rising wedge pattern, which is a bearish formation. This setup comes into play on a breakdown from the trendline support. Until then, the S&P 500 can continue rising within the wedge. Hence, we shall wait for the price to break and close below the wedge – below 2400 levels – to initiate our short position.
On the daily charts, we find that the index is rising in a channel. The support zone on the index is between 2400-2420. If the index breaks this support zone, it is likely to fall to the channel support line at 2320 levels, which is also a significant support. We expect the index to find a strong support at these levels.
Hence, our short position will be taken at 2395 with a stop loss of 2455 and a target objective of 2320. We risk 60 points for a gain of 75 points. Once we enter our trade, we shall try to lower our stop loss and trail it to reduce our risk.
Traders can use the ProShares UltraPro Short S&P 500 ETF (NYSEARCA: SPXU) to initiate the short positions. As this is an inverse ETF, please buy it at the existing value when S&P 500 hits 2395 levels. We shall sell our position at the existing level when the S&P 500 hits 2320 levels. Once we enter the trade, we shall keep the lows as the stop loss.