We have witnessed a phenomenal run in the Dow Jones recently. The benchmark index closed higher in each of nine trading sessions prior to Thursday. The S&P 500 has been also hovering around record highs. It took some mixed earnings reports and pressure on oil prices to push the Dow Jones lower on Thursday. While the index closed higher on Friday, I expect a correction.
Correction On the Cards
Nothing seem to be having an effect on bulls. Brexit came and went. There are concerns over the state of Italian banks. But investors are sidestepping all these issues. One reason could be that investors believe that the U.S. economy is in a relatively better shape when compared to other developed world economies. This is certainly true. But even then current valuations do not seem justified. The S&P 500 is now trading at a multiple of 25x earnings. This is well above the mean of 15.6x earnings. At the same time, earnings have been declining.
According to FactSet, the blended earnings decline for the second quarter of 2016 (after 7% of the companies in the S&P 500 had reported) was 5.5%. Of course, these are still early stages in the second-quarter earnings season. But if the trend continues we will have a fifth straight quarter of year-over-year declines in earnings. FactSet notes that this would be the first time such a thing would occur.
Looking at the fundamentals, the current valuations are certainly not justified. The weak earnings trend could in fact continue in the third quarter as well, as U.S. companies will feel the impact of a stronger dollar. The dollar strengthened post the Brexit vote, which came at the end of the second quarter. The full impact will be felt in the third quarter.
As I have said before, this is a liquidity driven rally. Central banks, led by Fed, have been printing money, keeping an unsustainable rally alive. However, I believe that a correction is on the cards given global economic uncertainty.
More than the second-quarter earnings, what investors are more concerned about is the impact of issues such as Brexit, the U.S. Presidential election and interest rates on outlook. FactSet said in a recent report that searched specific terms in the conference call transcripts of 30 companies in the S&P 500 that had reported through July 14th. The term "currency" was cited the most in calls, according to FactSet. This quite clearly highlights investors' concern about the impact of exchange rate and stronger dollar on bottom-line. The other terms cited often included Brexit, which does not come as a surprise.
While the U.S. economy is in a relatively better shape when compared to other developed world economies, it is not immune to events in the euro zone and the U.K.
The question is how to position for a correction. I believe that the Direxion Daily Small Cap Bear 3X Shares (NYSEARCA:TZA) is worth a look. The ProShares Trust Ultra VIX Short Term Futures ETF (NYSEARCA:UVXY) is also a good way to play a possible correction. Volatility usually rises sharply when we see a correction in the S&P 500 as the chart below shows. We saw a sharp rise in VIX in the first two months of this year when the S&P 500 saw a sharp pullback. When the market rebounded VIX fell sharply only to bounce back post Brexit. As S&P 500 has hit new record highs in recent weeks, VIX has once again fallen sharply.
Bearish on Oil And XLE
As I discussed in my previous article on the United States Oil ETF (NYSEARCA:USO), oil market's fundamentals are not as strong as initially though. Sentiment has turned bearish amid a glut in the downstream market. The concern is that a cut back in production from refiners would hurt demand for crude.
Meanwhile, crude exports from Iraq are expected to rise this month. Iraq is the second largest producer in the OPEC.
Year-to-date, the Energy Select Sector SPDR ETF (NYSEARCA:XLE) is still up more than 13%. From its February lows, the ETF has gained almost 26%. But with the outlook on oil turning bearish, XLE could see a sharp pullback. The Energy sector is expected once again report disappointing earnings. According to FactSet, the sector could see the largest year-over-year decline of all 10 sectors in the S&P 500. I am watching the Direxion Daily Energy Bear 3x Shares ETF (NYSEARCA:ERY) to capitalize on the bearish trend in the energy sector.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.