Now that stocks have finally started to pull back from record highs investors are probably asking themselves, 'is this a standard correction or something more than that?' I believe we are in the process of forming a major top and here's why:
- Earnings in the retail sector have come in weak. Abercrombie & Fitch, Dick's Sporting Goods, JC Penney, Macy's, Nordstrom, Target and Wal-Mart have all reported weaker-than-expected sales recently. This kind of pervasive weakness in consumer spending suggests the economy may be decelerating at a faster pace than most investors or economists currently believe
- Long-term technical indicators are flashing warnings. Multiple Hindenburg Omens have been triggered over the past few months and on the monthly charts both the Nasdaq and the S&P 500 have triggered DeMark sell signals. Notice that the Nasdaq 13 triggered just as it ran into the 61.8% Fibonacci retracement of the bursting of the Internet bubble. And we also have an interesting 13-year (and 6.5-year) cycle peaking right now that lines up with the 1987, 2000 and 2007, stock market peaks.
- We look to be far closer to the greed side of the sentiment cycle than the fear side. It has been over 2 years since the VIX "fear index" has risen above 40. The demand for put option protection is nearly nonexistent as investors see no need to protect their portfolios when stocks just go straight up like they have for most of this year. Finally, margin debt has exploded this year, reaching levels not seen since the stock market's prior peaks in 2007 and 2000 suggesting investors are just as euphoric today as they were then.
- Stocks are currently valued at levels seen only at prior major market peaks. What's more the historically high valuations are based on record high profit margins. Should profit margins simply revert to mean levels along with valuations stocks could easily lose half their value as they did after the 2000 and 2007 peaks.
- The rise in interest rates could have major repercussions on economies and financial markets around the world. The 1987 crash came on the heels of an interest rate surge that is very similar to what we have seen over the past couple of months. As I wrote last week, these types of events typically have all kinds of unforeseen "butterfly effect" consequences in markets around the world.
- Emerging markets are already showing cracks and this could be the canary in the coal mine for developed markets like ours. The last time we saw the sort of market action we are now seeing in Asia was during the 1997 and 1998 "financial contagion" events. Investors have typically been wise to heed these kinds of warnings in the past.
- Another area that looks vulnerable to the interest rate rise is housing, which has been a major source of economic strength recently. Robert Shiller, Yale professor and author of "Irrational Exuberance," recently said he sees excessive speculation in housing once again that will inevitably be reversed. Should this crucial sector begin to weaken due to the run up in interest rates it could once again become the economy's "achilles heel." This surely would not be a boon to financial markets.
- Finally, investors appear to be losing confidence in the Fed's ability to support asset markets of all kinds (stocks, bonds, real estate, etc.) via quantitative easing. This could result in investors abandoning risk assets, a shift that would surely mean a major bear market is under way.
My advice? In the words of Yogi Berra, "you can observe a lot just by watching." Investors would do well to take some risk off and simply watch how this unfolds.
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