Wednesday, March 26, 2014

A Stock Market Peak is Probably Near

The S&P 500 has made marginal new all-time highs this year, finally exceeding the 1999 peaks.   However, adjusted for inflation, it's still not at a new high.   One could argue that the broad market has gone nowhere in 14 years -- with a paltry 1% annual gain in price (or 3% annual gain if you include dividends).  There is pretty good history that market cycles last about 17 years, so if history is any guide, we have a 2 to 3 years of a struggling market.  Take a look at the chart below.

Secular Stock Market Cycles Average About 17 Years -- Both Bear and Bull Markets -- The Current Bear Market cycle is only 14 years in Duration
Here are some of the many signs of a stock market top:
  • the Russell 2000 small cap index is trading for 49 times reported earnings, compared with a multiple of 39 in March 2000 (the peak of the dot.com bubble).  That's 26% ABOVE the sky-high valuation at the dot.com bubble peak!
  • Stimulus by Central Banks in China and US being removed (until markets crash).  Europe is slipping slowly into recession due to the Euro currency that is hurting the trade competitiveness of most Southern European countries and France. Also, no quantitative easing in Europe expected due to German resistance (until markets crash).
  • The long-term market's price-to-earnings ratio, the Shiller PE (the Cyclically Adjusted PE or CAPE) is 24 which is above the long term average of 16.5.  By this measure, you could say that the S&P 500 is overvalued by about 44%.  
  • The S&P 500 valuation is in the top 10% of valuations in the past 100 years of market history -- and much of those top 10% valuations were during the late 1990s.
  • According to John Hussman (a highly respected money manager and a investor advisor for investment advisors), the projected 10 year return for the S&P 500 is only 2% with expected returns negative for any time frame shorter than 7 years. (His methodology has a 90% statistical confidence level).  Interestingly, his 10 year expected return for bonds is also only 2% which adds up to a grim picture for investors for the next decade.  My advice:  wait for significant pullbacks in the months and years ahead to commit capital in order to take advantage of the declines.
  • Jeremy Grantham, who correctly called the 1999 market peak, agrees with Hussman that expected returns for the market NOW is negative for the next 7 years. See my blog covering Grantham here
  •  A "gold rush" of IPOs has started this year, many of the IPOs with thin investment stories and not many making money (no earnings).  There is a crowded IPO schedule in the months ahead.  This gold rush is one of the more reliable signs of market "froth" and long-term market tops in combination with elevated valuations after a long bull run.
  • The quality of earnings is deteriorating.  Many company earnings being reported are non-GAAP earnings and many earnings reflect regularly occurring "non-recurring" items -- adjustments that "juice" earnings.  Much of "improved" bank earnings are due to draw-downs of loss reserves while China (and Asia) has the "worst financial credit bubble in modern world history" that is about to burst.  Bank corporation "mark-to-market" accounting has been thrown out.  More items are "off-balance sheet."
  • Earnings"engineering" has been a big driver of stock market earnings during the entire 5 years bull market since March 2009.  Companies sell bonds or borrow from banks at extremely low Fed-engineered interest rates and buy-back their stock shares.  This has been THE major driver in driving up stock market prices in the last 5 years.  Individual investors, until recently, have not been buying stocks.  Corporate leverage is higher magnifying earnings per share -- call it earnings "engineering."
  • Corporate earnings are peaking, a reversion to much lower mean is one of the most reliable aspects of financial history.  See my blog The Stock Market is Expensive.
  • In-the-know insiders are selling hand over fist.  From Mark Hulbert at Marketwatch, "corporate officers and directors in recent weeks have sold an average of six shares of their company’s stock for every one that they bought."  Insiders are "as pessimistic as I’ve ever seen over the last 25 years,” 
  • In many ways, economic fundamentals are no better than in 2007.  The economic "recovery" has been poor.  Employment has not recovered to pre-crash (2007) levels.  Despite noise to the contrary, housing construction has barely improved since the 2009 bottom.  Mortgage applications are again back to low levels seen in 2009 and 2010.  There is more corporate and government  debt, the big banks are bigger and more dangerous, "Flip that House" is back on TV,  government debt around the world and especially in China and Asia is dramatically higher, and Europe is stuck in near-recessionary conditions thanks to the Euro currency and higher debt.  
  • From Hussman, the Dow Utilities peaked on April 30 2013, the Nikkei peaked on December 30 2013, the Dow Industrials peaked on December 31, the Dow Euro Stoxx 50 Index peaked on January 15, the German DAX peaked on January 17, the London FTSE peaked on February 24, Russell 2000 peaked on March 4, the Nasdaq 100 peaked on March 5, the NYSE Composite peaked on March 6, the S&P 500 and Dow Transports peaked on March 7. All of these peaks may be breached, of course, but we’ve always noted that a loss of uniformity tends to precede major market declines, and this sort of action is of particular concern in the context of an overvalued, overbought, overbullish, rising-yield syndrome.
Stock market valuations are sky-high based on engineered and manipulated earnings while signs of a speculative IPO frenzy and sudden interest in equities by the retail public all signal an impending top in stock prices.  The timing of this top is always uncertain.  It could go on longer.  And I could be wrong, but I would have a lot of distinguished company.

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