Evidence Is Piling Up That The Market Is In For A Downturn

Includes: DIA, IWM, QQQ, SPY
by: David White


The 25.16 CAPE for the S&P 500 is far above the average of 16.53.

The margin debt peak has marked recent downturns; and we are likely seeing one.

The Fed is tapering (tightening).

The Chinese manufacturing PMI for February 2014 was 48.5; and the trade deficit for February was -$23B versus an expectation of +$6.8B.

There is a huge amount of Chinese debt that will have to be written off; that the Chaori effective default was allowed may signal write-offs are coming.

For the last several months I and numerous other people have pointed to such indicators as the too high CAPE (cyclically adjusted PE) of the overall market, the huge amount of margin debt (money borrowed to buy stocks), the Fed tapering, the fiscal and political troubles in the emerging markets, the inventories build up in the US, a still very troubled EU, and the overall softening of US statistics. These by themselves amounted to huge reasons for the US equities market to turn downward. A list of reasons is below.

  1. The CAPE for the S&P500 is at 25.16 for March 2014. This is a sign that the market is overheated. This is more than 52% above the long term average of 16.53. How often would you buy a stock, if you thought the stock was 52% overvalued?
  2. The $451B peak in margin debt in January 2014 is another sign of an overheated market. The chart below shows just how well margin debt peaks correlate with market downturns.

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  1. The above chart looks pretty convincing. The problem is that one can never be completely sure when the peak before the fall has been put in. Further JP Morgan (NYSE:JPM) analysts argue that the margin debt example may be partially misleading. Hedge funds borrow disproportionately; and the amount of money under management in hedge funds is at an all time high. Still JPM's argument only means that there is uncertainty with regard to the top. It does not mean that the market is not in danger of a significant pullback or even a crash. Even the "net debit reading" that the JPM people prefer is approaching a record high last seen in February 2000. Even they are concerned. Net debit is the total debt in customers' margin accounts minus the total monthly cash and credit in the accounts. Presumably this leaves out hedge funds entirely.
  2. The Fed tapering is in fact Fed tightening. Theoretically this should slow down the economy as money should become less easy to obtain. It is a negative stimulus. It is a "risk off" indicator; and it should move money out of risky assets such as overvalued stocks. Already we have seen the 10 year US Treasury Note yield shoot up from a May 2, 2013 yield of 1.63% (when tapering talk started in earnest) to 3.03% on December 31, 2013. It has since fallen to 2.76% as of this writing March 12, 2014. However, many think this is the result of a flight to quality due to the worrisome emerging market political and economic problems. That the yield is going counter to logic in a tightening environment is also a big tell that a market pullback/crash may be imminent. Again this would be a good reason to get out of risky assets.
  3. The emerging market country most in the news recent has been the Ukraine. Its temporary government has said that it needs $35B in aid. It has $15B of that debt that is due this year. It needs a "bailout"; and it will apparently a get a $15B bailout from the EU and the IMF. The US by itself has pledged $1B in loan guarantees. On top of this it has political problems with Russia. It is seemingly having to fend off a hostile takeover by Russia. The EU and the US are trying to help with this. However, their threats against Russia for its imperialist actions also put them in danger of entering a trade war with huge energy exporter Russia.
  4. In addition to the Ukraine, Turkey, Thailand, and Argentina are current hotspots of economic and political instability. Turkey in January 2014 had to raise its overnight lending rate to 12% from 7.75% in order to stabilize its currency. Argentina and many other countries have recently seen their currency fall dramatically against the USD. The chart below shows the high rate of inflation.

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  1. Since the beginning of 2011 the Argentine peso has fallen from 4 to the USD to 8 pesos to the USD -- roughly 100% inflation in about 3.25 years. This has made it very hard for Argentina to pay its bills that are denominated in USDs. I could go on, but readers should be getting the idea. With lending in the EU and the US demanding higher standards for loans, the emerging markets Euro and USD funds are drying up. This is causing accelerated inflation worldwide. It is putting increased pressure on most or all of those economies.
  2. In the US, the first estimate of Q4 GDP growth was revised downward from 3.2% to 2.4%. On top of that the level of inventories seems to be increasing far out of line with the economic growth. The inventory build portion of the US GDP growth usually amounts to about +0.4% of the GDP growth. In Q3 2013, this amounted to +1.7% of GDP growth . In Q4 2013 it amounted to +0.8% of GDP growth. This amounts to +1.7% more than one would expect. These gains were not offset by great Retail Sales gains. In fact Retail Sales fell -0.4% in January 2014 and -0.1% in December 2013. As confirmation wholesale inventories rose by +0.6% in January while wholesale sales fell by -1.9%. The inventory to sales ratio rose from 1.18 months in December 2013 to 1.20 months in January 2014. November 2013's ratio was 1.17 months. With flat to declining Retail Sales, such increases in wholesale inventories are untenable. They indicate that their GDP growth component may have to be no more than the average +0.4% per quarter in 1H 2014 in order to compensate for the large contributions in 2H 2013. These numbers aren't the levels of 2008-2009, but a new recession has not started yet. Still they do indicate GDP growth in future quarters should be lower. The graph below shows the typical levels of wholesale inventories to sales ratios.

  1. The US is in the high end of the normal ratio. That probably means lower GDP growth in 1H 2014. If you subtract half of the extra +1.7% on average inventory growth in 2H 2013 from the 2.4% level of Q4 2013 GDP growth, you get +1.55% GDP growth. If you further subtract about -0.5% to compensate for this winter's cold snap, you get a ballpark GDP growth level of roughly +1% for Q1 2014. This is significant slowing. The January data indicates that the US has not yet started to scale back on wholesale inventories growth; but this is likely to come soon. Perhaps it started in February.
  2. The EU troubles are far from over. The Euro Area PPI was down -1.4% year over year in January 2014 and -0.3% month over month. Deflation is usually a sign of recession rather than recovery. Further the EU is facing a possible energy embargo from Russia due to disagreements over Ukraine. That would hurt a large number of EU countries. The PIIGS are still in trouble. I could go on.
  3. More recently China has been showing acute signs of weakness. The final Chinese Markit/HSBC manufacturing PMI for February was down to 48.5 (contraction) from 49.5 (contraction) in January 2014. The Chinese PPI for February 2014 was down -2.0% year over year. On March 7, 2014, Shanghai Chaori Solar Energy Science & Technology Co. failed to pay full interest on its bonds. The market is worried that this may signal the beginning of a huge stream of Chinese defaults. Debt-to-equity ratios exceeding 200% for Chinese companies have jumped 57% since 2007. On March 10, 2014 the Chinese export data showed a -18.1% contraction year over year versus an expected +6.8% gain. This led to a negative Chinese Trade Balance for February 2014 of -$23B. Some say this was due to the New Year celebration, but the Trade Balance last year for February was +$15.25B. That is +$38.25B more positive. In response to the trade data iron ore prices fell -8.3%. Coking coal prices went down the day limit of -4%. Dr. Copper was down to an intraday low of $2.9955/pound; and it fell again on March 11, 2014.
  4. In addition to the above more immediate concerns, Chinese local governments are said to have $2.95T in debt as of June 2013. Many of those local governments do not have the ability to pay such monies back. Further it is not just the debt but the growth rate of the debt that is troubling. It has grown 67% between 2010 and mid-2013. Some of this debt is owed to the shadow banking system, which has even shorter maturities than standard banks. The shadow banking system itself is troubled. It has $4.8T in debt that is of dubious quality. Once the bloodletting starts the situation in China could get ugly very quickly; and I haven't even mentioned a lot of business loans that were made with the expectation of 10%+ GDP growth per year. Just as an example, Moody's Investment Service said in a November 5, 2013 report that only 53% of 388 Chinese construction companies it surveyed in June 2013 had enough cash to cover estimated debt payment and interest this year (2013) without refinancing.
  5. It is hard to say when this whole system will fall apart, but it is getting increasingly worrisome. It seems almost sure to happen in the next several years. After all how can local governments keep growing their largely unrepayable debt at the rate they have been. How can half of the construction businesses continue refinancing in order to just squeak by, especially when that refinancing is likely through the shadow banking system at higher rates. China may have $4T or so in debt that has to be written off. Should it wait until it has $6T that has to be written off? Or should it just bite the bullet now? In two to three years the debt to be written off amount could be $6T at the current rate of bad debt growth. The government has to know this. The only question about a Chinese financial crisis seems to be when it will occur. The answer could be now. Investors should act with this in mind. The now five year old US bull market in equities is getting long in the tooth without all of the above rational.
  6. With only +0.5% growth in EPS now predicted for Q1 2014 earnings, now may be a good time to take profits. The two year chart of the SPDR S&P 500 (NYSEARCA:SPY) gives some technical direction for this trade.

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The slow stochastic sub chart shows that SPY is at overbought levels. The main chart shows that it is in a strong uptrend. Technically almost anything could happen from here. Fundamentally, the overall market should fall; and it should take the SPY with it.

The two year chart of the SPDR Dow Jones Industrial Average (NYSEARCA:DIA) provides some technical direction of the DJIA stocks.

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The slow stochastic sub chart shows that DIA is at overbought levels. The main chart shows that it is in a weakening uptrend. Technically almost anything could happen from here. Fundamentally, the overall market should fall; and it should take the DIA with it.

The two year chart of the Power Shares QQQ (NASDAQ:QQQ) provides some technical direction for the technology part of the market.

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The slow stochastic sub chart shows that QQQ is near overbought levels. The main chart shows that it is in a strong uptrend. Technically almost anything could happen from here. Fundamentally, the overall market should fall; and it should take the QQQ with it.

The two year chart of the iShares Russell 2000 (NYSEARCA:IWM) provides some technical direction for the small cap portion of the market.

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The slow stochastic sub chart shows that IWM is at overbought levels. The main chart shows that it is in a strong uptrend. Technically almost anything could happen from here. Fundamentally, the overall market should fall; and it should take the IWM with it.

In sum the technicals are not telling you to sell. However, they do indicate that there could be a roll over at this time. The fundamentals are telling you very loudly to sell. The problem is that the market does not necessarily follow the fundamentals with precise timing. However, the recent, very troubling data out of China could be a market mover. The Ukraine situation is pushing the market toward a downward move too. The myriad of other fundamental factors are too. China may be the straw that broke the camel's back. This market may be in the process of starting a significant down move. Watch Dr. Copper. Watch the Chinese markets. Watch the news about Ukraine. To be safe start to take some of your investment money off the table. Perhaps buy some puts on the market to protect your portfolio.

Some of the above fundamental fiscal data is from Yahoo Finance.

Good Luck Trading.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.