Listening to the media, reading bank research reports, and scanning investment articles on articles on sites like SA, we are faced with a plethora of arguments both in favor of a continuation of the equity rally and advocating to exit stocks before the imminent correction. On one hand we hear: "valuations are not excessive" ; "don't fight the Fed's easy monetary policy" ; "the rally is 'unloved' (insinuating optimism is not too bullish)" ; or "U.S. stocks are the only game in town". On the other hand, many argue that a -10% correction is approaching ; that markets are actually expensive based on Shiller P/E's ; that Iraq/rising oil prices will de-track the rally, etc.
Making an investment decision faced with all this "noise" is challenging to say the least. Moreover, since the last correction in August 2011, the S&P 500 (NYSEARCA:SPY) has seen about 10 pull-backs ranging from -3% to -9%. Each case proved to be good buying opportunity. Will the next pull-back be once again a buying opportunity?
At Williams Market Analytics, all our investment decisions are taken systematically, based on a disciplined market indicator approach. While our models have kept us fully invested during the numerous pull-backs since 2011 (although we have been essentially out of U.S. stocks since March, see A Novel Idea: Sell U.S. Stocks Into Strength), we are prepared to raise cash. We are monitoring six indicators that will determine for us if the next pull-back is the one to finally sell :
1.) Stock / Bond Ratio
The ratio of the S&P 500 to the U.S. Long Government Bond captures very well the interest rate induced distortion in financial markets. Since the 4th quarter of 2012, the stock market has outperformed U.S. Treasuries by over 60%. Interestingly, the ratio has been topping out at the exact same level as the 2007 peak, as shown in the chart below. Our first indication that the next stock market sell-off may be more serious would be the long-awaited breakdown of this ratio, dropping through the 200-day moving average (dashed blue line).
2.) Deterioration of Advance/Decline Line
The advance/decline (A/D) line is a breadth indicator which measure of the number of individual stocks participating in a market rise or fall. With the broad market rally, the A/D line on the S&P500 has been in a particularly strong uptrend for the past 20 months (see chart below). A second indication of a more severe correction would be a break of this uptrend. We have set alerts both below the 100-day moving average (dotted blue line) and after a -15% draw-down on a 10-day smoothing of the A/D line.
3.) Confirmation of Risk-Off
We previously signaled a key negative divergence of our proprietary risk indicator back in April (see The Equity Cyclical Bear Market Of 2014). For a description of our indicator, click here. We believe the indicator is in "dead cat bounce" mode, just as the indicator ticked up briefly in 2011 and in 2007 before the sharp corrections. We would like the indicator to confirm the divergence by turning down and remaining below the dashed signal line in the chart below.
4.) Move towards Pessimism
While there is much dispute over the overall mood of investors (some claim the bull-market is still unloved, other cite surveys like the AAII at 6-month bullish highs), our proprietary sentiment indicator has re-entered the "extreme optimism" mode. For a description of our indicator, click here. Sentiment is typically used as a contrarian indicator, as one should sell when investors are collectively euphoric. As sentiment has remained persistently optimistic for the past 24-months, we would like to see our indicator fall below 68.0 to confirm growing distrust of this market (see chart below).
5.) Spike Up in Volatility
Many had called for more volatile markets this year, but paradoxically we have instead seen multi-year lows in the VIX (volatility on S&P 500 options). While traders love volatility, longer-term investors, including pension funds, institutional, and retail, become quite nervous. As a result, rising volatility is usually associated with falling equity markets. We believe the current complacency of investors would take a serious hit if the "Fear Index" climbs above 22.0 (dashed red line). We have set an alert above this key level, which has marked the apogee of volatility since 2012.
6.) Upward Pressure on Rates
For a durable, deep correction, longer-term investors must feel real anxiety and have an identifiable cause to sell-out of their stock holdings. Uprisings in Ukraine, jihadists in Iraq, Congressional election upsets are all white noise for intransigent bulls and will only cause a hiccup in equity markets.
The next severe correction will be fueled by one single cause. Capitulation by long-term bulls and forced selling by highly leveraged margin speculators will only occur when the true source of the equity bull market is threatened…..easy money.
Note that we believe the mere threat of higher rates will be sufficient to provoke a full cyclical bear market (-20% on the S&P 500). We are therefore monitoring both short-term and long-term pressures on interest rates. The short-end of the yield curve is dominated by Federal Reserve monetary policy. As most readers understand, the Fed has a duel mandate: stable prices and full employment. Although monetary policy is an ineffective tool for increasing employment, members of the Fed cling to the belief that they can create jobs. After 5 years of extraordinary monetary policy, we are still left will sub-par economic growth and stubbornly high unemployment. For a hammer everything looks like a nail, just as for a central banker every problem can be solved with quantitative easing and zero-percent interest rates. As such, the Fed will remain in crisis mode until they have to address their second mandate, inflation.
The Fed's favorite measure of inflation is the Core Personal Consumption Expenditure index. However this is a 2.5-month lagging indicator. A more timely, market-based measure of inflation are breakeven spreads on U.S. Treasuries. By taking the difference between a nominal T-Note yield and the real yield on an equivalent maturity Treasury Inflation Protected Security, one arrives at the bond market's outlook for inflation. We are monitoring the 5-year breakeven spread shown on the chart below. When the spread climbs above 2.5% (key level, denoted by red dotted line), we anticipate the market will finally beginning forcing the Fed's hand. Astute, forward-looking investors will at this point begin to discount an earlier start to the next Fed tightening cycle. These anticipations will of course be reflected in equity prices.
Similarly, we are watching pressure on the long-end of the curve as well. Make no mistake, much of the current equity bull market is due to companies borrowing money (at dirt cheap rates) in order to pay dividends and buy-back shares. Indeed, irresponsible corporate actions are bred from irresponsible monetary policy. Higher longer-term rates will help put an end to this nonsense. We are watching both the yield on the U.S. 10-year note and the 30-year lending rate. As shown by the red horizontal lines on the chart, we are monitoring 3.0% on the 10-year and 4.6% on the 30-year. We believe these are important levels, above which the largess of corporations will be significantly reined in. Moreover, higher rates will eventually give investors an alternative to equity markets. The flow of money from stocks and into bonds will also fuel a stock market correction.
We believe the down-side risk of U.S. equities greatly outweighs the up-side potential. Longer-term, buy and hold investors, who are not watching a Bloomberg terminal each day, should be especially vigilant. We continue to recommend diversifying into relatively cheap foreign stocks with good relative strength (as indicated by our models) and raising cash when our six indicators begin to deteriorate.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.