Are Stocks Out Of Gas?

by: Andrew Hecht

Summary

No follow through from an accommodative Fed.

Valuations are too expensive.

The election weighs on equities.

Upside is a struggle, downside is not.

Time for protection after quarter-end.

The story of the stock market since March 2009 has been nothing short of a grand saga for investors. The E-Mini S&P 500 index has rallied from 665.75 in March 2009 to highs of 2191.50 in August 2016. Stocks have appreciated by over 229% over seven years. Money continues to flow into the equity markets for two reasons.

First, there have been few other asset classes in the world that offer the opportunity for both asset growth and dividend yield. That powerful combination has caused capital to flow in to stocks. Second, and perhaps more significantly, a higher stock market has become a self-fulfilling prophecy. Herds of investors, traders, and speculators around the world have flocked to stocks. Low interest rates and central bank monetary policy around the world have caused many companies to buy their shares as management pay is often a result of the price of a company's shares. With investors following companies, the bull market in stocks has run a long way making its most recent highs just weeks ago. However, there are signs that the air is thin at current levels of equities, and we are on the verge of a selloff of epic proportions.

No follow through from an accommodative Fed

The latest Fed meeting last week provided markets with more of the same. Over 80% of market participants did not expect any interest rate hike from the Fed, despite the hawkish tone of statements from many officials at the end of August.

Since last week's meeting and inaction by the central bank, stocks have been moving around but have gone nowhere fast.

Click to enlarge

Source: CQG

As the chart of the E-Mini S&P 500 index highlights, an initial rally after the Fed told markets there would be no rate increase ran out of steam quickly. As of Tuesday, September 27, the futures contract remains around the post-meeting level.

There are reasons why equity prices are likely approaching highs here and one significant event on the horizon that could mean that this is the time to act to lock in profits this year and prepare for an ugly correction in the weeks and months ahead.

Valuations are too expensive

There cannot be many arguments that most stocks are expensive at current levels.

Click to enlarge

The current Shiller price to earnings ratio is at the 26.79 times earnings level. As the chart dating back to the late 1800s illustrates, company valuations are at historically high levels. Over the coming six weeks, we are likely to see increasing volatility across all asset classes as the U.S. Presidential election on November 8 is fast approaching.

The election weighs on equities

On Tuesday, we saw a rally on all of the major equity indices after many analysts interpreted the first debate between Hillary Clinton and Donald Trump as a win for the incumbent party. During the debate, Trump pointed to the low interest rate policies of the Fed as a reason for "bubbles" developing in many asset markets including stocks. "If you raise interest rates stocks could come crashing down," according to the Republican nominee.

While Clinton may or may not have bested Trump in the first debate, there are two more in the coming weeks. Anyone who watched Trump's rise over the last year would caution against writing the Republican candidate's chances off in the general election at this point. The close contest is likely to result in continued volatility across all asset classes. When it comes to volatility, in 2016, stock prices have taken the stairs up and the elevator down.

Upside is a struggle downside is not

S&P 500 is up around 4.9% for the year, but 2016 began in ugly fashion.

Click to enlarge

Source CQG

The weekly chart of the E-Mini S&P 500 futures contract illustrates that the index fell by 11.5% over the first six weeks of 2016 as Asian-contagion hit global markets. Stocks have posted gains since the February 11 lows, but as the chart shows, the down moves have been more aggressive that the rallies.

Since making all-time highs in late August, stocks have struggled to remain at lofty levels. The hawkish statements of the Fed leading up to the most recent meeting caused selling in bonds and equity markets, but when the Fed decided to leave monetary policy unchanged last week, the selling pressure abated. Now, we face a quarterly event that could mean stocks will edge higher over the balance of this week providing investors a chance to lock in profits before the likelihood of a selloff rise with the arrival of October and the fourth quarter.

Time for protection after quarter end

Quarter end is always an important benchmark for investors and fund managers alike. Investors will receive monthly statements of their portfolios, and while many do not watch the markets on a day-to-day basis, the quarterly statement is often the critical measure of performance.

When it comes to fund managers, there are two significant aspects to the end of each quarter. First, the performance of their strategies will either keep investors with them or not. If they post gains, the chances are that their assets under management will remain steady or grow. If they lose money, the opposite occurs. Second, when they make money, their compensation is often a function of gains. Therefore, it behooves fund managers to see markets close at the best possible level on the final trading day each quarter. With so many investors in the stock market, that means that there is tremendous vested interest in a high close this Friday. Fund managers often save buying for the end of trading on the last day of each quarter to ensure a happy client base and fill their pockets with incentive compensation.

With so much uncertainty in markets today, with the Presidential election only six weeks away, and with valuations so high, this could be the perfect week to lock in profits or take some protection for portfolios before October arrives. The recent action in stocks tells me that the market could be running out of upside gas. Downdrafts in the stock market are ugly as many run for exits at the same time. It makes sense to act before the end of the third quarter as the market action is likely to allow plenty of time to get back in if stocks continue their upside momentum in October and over the rest of 2016. However, if the market decides to correct the down move could become gruesome as it was at the beginning of this year.

I have introduced a new weekly service through Seeking Alpha Marketplace. Each Wednesday I will provide subscribers with a detailed report on the major commodity sectors covering over 30 individual commodity markets, most of which trade on U.S. futures markets. The report will give an up, down or neutral call on these markets for the coming week and will outline the technical and fundamental state of each market. At times, I will make recommendations for risk positions in the ETF and ETN markets as well as in commodity equities and related options. You can sign up for The Hecht Commodity Report on the Seeking Alpha Marketplace page.

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.