Authored by James Stack via InvesTech.com,
From public confidence to bullish sentiment to the normally mundane employment data, the U.S. economy and stock market are reaching historic levels not seen in decades. Last month, consumer confidence hit its highest level since December 2000. The percentage of bullish investment advisors recently touched lofty levels that were last reached in January 1987. And this month, the U.S. Department of Labor announced that job layoffs dropped to a 44-year low!
This might all sound like great news, and on the surface it obviously is. But what is forgotten in today’s exuberant celebrations - and the above statistics - is that both the economy and stock market historically peak when skies are blue and no storm clouds are in sight: December 2000 was just 3 months before the start of the 2001 recession. January 1987 was 9 months before Black Monday struck. And 44 years ago (1973), the stock market was about to suffer its worst annual loss in 35 years! If the S&P 500 closes higher in November, it will have posted a positive total return for 13 consecutive months, surpassed only once in 90 years – 1959. The next year (1960) the economy entered a recession.
We’re not sharing these insights because we have turned bearish in our market outlook. We haven’t. Most technical evidence and virtually all macroeconomic data still point to new bull market highs immediately ahead. However, it is becoming increasingly important to remember that trees do not grow to the sky, and bull markets do not last forever. And don’t forget that virtually every bear market except one (1956) has repossessed or taken back roughly one-half or more of the previous bull market’s gain.
Today, that would equate to 8,500 DJIA points!
Unbridled Exuberance... While the Novice Make Merry, the Seasoned are Wary
One of the most apparent examples of investors’ increased appetite for risk lies in the “FANG” stocks. These modern day “four horsemen” of technology and consumer stocks –Facebook, Amazon, Netflix, and Google– are considered leaders in the emergent areas of today’s economy. Because of their outsized estimates for future growth, this narrow group of stocks has radically outperformed the S&P 500 since the beginning of 2015.
However, value-conscious investors have had difficulty justifying ownership of this speculative quartet due to valuation risk.
They trade at a combined P/E ratio of 48.5 based on trailing earnings – nearly twice that of the S&P 500.
Enthusiasm for the FANG stocks has reached such a feverish pitch that Wall Street is creating new products to tap into the public’s insatiable appetite for these exciting invest ments. The four FANG stocks are joined by six other hot tech names to form the NYSE FANG+ Index. Futures contracts on this Index began trading on the Intercontinental Exchange (ICE) last week. Investors can now “Trade the Top of Tech” in the futures market to quickly increase or decrease their exposure to these speculative companies.
In past market tops of the late 1990s and 2007 we exposed the danger of investor and consumer exuberance along with the “boom” headlines that typically accompany a cyclical peak. This is not an infallible relationship, however, so the appearance of the above headlines today does not necessarily mean the market top is in place. Rather, it reinforces the need to maintain professional skepticism and an emphasis on risk management, which can be in short supply at this stage in the market cycle.
Nowhere is the bullish consensus more obvious than in the Advisors Sentiment Survey tracked by Investors Intelligence (graph below). While the percentage of bears is typically considered a more reliable contrarian indicator at extreme readings, we find it interesting to note that the percentage of bullish advisors recently hit the highest level since January 1987 – only nine months before the 1987 Crash…
Valuation risk remains an overarching concern for today’s aging bull market. Although the leading economic evidence remains overwhelmingly positive, U.S. stocks are not cheap by historical standards. The current P/E ratio of the S&P 500 based on trailing earnings is 24.8, which is well above the 90-year average, as shown in the graph below.
How expensive is the S&P 500 today? The P/E for this popular Index has exceeded 24.0 just over 10% of the time since 1928, as shown by the dark blue bars on the graph at right. The light blue bars eliminate the distortions from the Technology Bubble of the late 1990s and the Financial Crisis in 2008-09 when corporate earnings evaporated. If we exclude those extreme periods, the S&P 500 P/E ratio has been in the rarified range above 24.0 less than 3% of the time.
Lofty valuations do not cause bear markets, and stocks can remain overvalued for very long periods of time. However, high valuations increase downside risk and diminish the margin of safety so essential to successful long-term investing. Consequently, it is particularly important now to employ a safety-first strategy and avoid overvalued momentum stocks, as they will undoubtedly fall the hardest when a bear market does arrive.
A Potential Warning in the Technical Evidence...
Sometimes it’s striking how quickly the technical picture can shift in an aging bull market. Take the three graphs below, for instance. When we last published this trio of charts in early October, all three were hitting new highs in unison. Now both the Dow Jones Transportation Average (DJTA) and the small-cap Russell 2000 Index are starting to diverge substantially from the blue chip DJIA, which is sitting just below its recent all-time high.
Major peaks in the DJIA are usually preceded by a top in one or more of the economicallysensitive secondary indexes, but not every divergence necessarily signals trouble ahead.
When both the secondary indexes shown here diverge simultaneously, however, it’s a significant development, and time for heightened vigilance.
NLC: Is Distribution Imminent?
Our Negative Leadership Composite (NLC) shown below remains steadfast on the surface with the bullish “Selling Vacuum” [*1] at +4 and no visible sign of “Distribution” [*2 – shaded region]… yet!
Even so, careful analysis of the underlying leadership data since mid-October shows a steady deterioration in the internal numbers.
Sometimes it’s striking how quickly the technical picture can shift in an aging bull market. Take the three graphs at right, for instance. When we last published this trio of charts in early October, all three were hitting new highs in unison. Now both the Dow Jones Transportation Average (DJTA) and the small-cap Russell 2000 Index are starting to diverge substantially from the blue chip DJIA, which is sitting just below its recent all-time high.
Major peaks in the DJIA are usually preceded by a top in one or more of the economically-sensitive secondary indexes, but not every divergence necessarily signals trouble ahead.
When both the secondary indexes shown here diverge simultaneously, however, it’s a significant development, and time for heightened vigilance.
Selling pressure is stealthily creeping upward, and it appears to be broad-based. If the current trend continues, we could start to see Distribution in our NLC by the time our December issue goes to press. If Distribution appears and subsequently drops below -50, then bear market risk will become elevated and that could warrant a more defensive stance