Most Signs Point To A Significant Market Decline Ahead

We would ignore all of the talk on Wall Street and in the media about whether the stock market is in a bubble. After all, that’s just a matter of semantics, and whatever we call it, the market is overvalued, overbought, and overly bullish at a time when the economy is slogging along at an inadequate pace, and depends almost solely on the prospect of continuing Quantitative Easing (QE) to continue its upward move.

The market doesn’t have to be in a bubble in order for it to be on the precipice of a significant decline. Of all the cyclical market peaks since 1929, only the tops in 2000 and 2007 were looked back on as being bubbles. Most of the other market peaks occurred with the P/E ratio ranging between 18 and 21 times reported cyclically-smoothed GAAP earnings, compared to a norm of 15 times and bear market lows between 7 and 10 times. At today’s market close the P/E ratio is 20.6 times earnings.
That’s high enough to be a potential market top, especially given existing fundamental and technical conditions.

The market has been moving like a yo-yo in response to the minute-to-minute perception of the prospect for Fed tapering.
Yesterday, the market tanked after the release of the Fed minutes indicated that a number of Fed members thought that tapering should begin before a definitive improvement in the economy became apparent. The specific paragraph that got the market’s attention stated, “….participants also considered scenarios under which it might at some stage be appropriate to begin to wind down the program before an unambiguous further improvement in the outlook was underway.” Until this statement, most investors assumed that winding down QE would only take place in a robust economy, and, therefore, would actually be positive. The idea that tapering could begin in the absence of real economic improvement was too much for investors, at least in the short-term.

Today, however, when the Philadelphia Fed Survey released results that were much weaker than expected, the 10-year bond yield abruptly dropped, and stocks soared on the grounds that maybe the start of tapering would be delayed after all. Such is the state of the current market. Everything hinges on QE, and little else seems to matter. The similarity between now and 2000 or 2007 is not necessarily that we are in a bubble, but that the reason for market strength rests on such dubious grounds.

In our view, the market is not supported by strong fundamentals.
The so-called strength in the economy is based on forecasts, rather than on current conditions. But forecasts have now been overly optimistic for the last three years, and we see no change in the period ahead. GDP has been growing at a 1.6% rate over the past year. Similarly, real consumer spending has been rising at a 1.8% rate, and real disposable income at 1.6%----and this with a powerful dose of QE. With the rise in mortgage rates, housing has also become a weak spot. October existing home sales were down 3%, while the pending sales index, which leads existing sales, indicate more declines ahead.

Technical conditions also point to a vulnerable market. Breadth has been narrowing and did not confirm new highs in the averages. Daily new stock highs peaked in May and recently have been trending lower. The Russell 2000 has been lagging the large-cap averages. Some speculative high-P/E momentum stocks have recently been hit hard. Tessler is down 37%, Cree 27%, Fleetmatics 26%, Facebook 15%, and Linkedin 14%.
Investors Intelligence bulls have averaged a historically high 54% and bears 16% over the past four weeks, numbers indicative of market extremes. According to Vanguard, investors, as a group, have a 57% allocation to equities, an amount exceeded only twice in the last 20 years----the late 1990s and prior to 2007-2009. All of these numbers belie the belief that most investors are still too pessimistic.

All in all, we believe that the market is facing significant headwinds, and that a major decline is not far off.

Information on these pages contains forward-looking statements that involve risks and uncertainties. Markets and instruments profiled on this page are for informational purposes only and should not in any way come across as a recommendation to buy or sell in these securities. You should do your own thorough research before making any investment decisions. FXStreet does not in any way guarantee that this information is free from mistakes, errors, or material misstatements. It also does not guarantee that this information is of a timely nature. Investing in Forex involves a great deal of risk, including the loss of all or a portion of your investment, as well as emotional distress. All risks, losses and costs associated with investing, including total loss of principal, are your responsibility.

RELATED TOPICS