Time To Short The S&P 500?

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 |  Includes: IWM, QQQ, SPY
by: TheRocketTrader

The US stock market posted a massive move higher on Friday leaving many investors wondering what to do next. No one wants to get left behind and the stock market cheerleaders press you from every angle. They passionately argue that stocks are cheap and are especially attractive relative to bonds or cash. They will argue that they are a great hedge against inflation. They will talk about the Bernanke put. They will talk about how little exposure the US actually has to Europe. They will even try and pull out the rule of 72 and after experiencing the massive easy money rallies of the last couple of years, it may be tough for you to believe otherwise.

Today I am going to be bold and lay out the case against stocks by looking at stock market valuations, economic data and market technical data.

Valuations

Stocks are cheap - right? Has your broker ever told you that they were expensive? The honest answer to this question depends on what criteria you use to measure valuations. Personally, I think that stocks are pretty darn expensive. Most of the people you hear pushing the "stocks are cheap" idea use the twelve month trailing P/E and by that measure, stocks do in fact look reasonably priced. This trailing P/E approach compares current market price to the trailing twelve month earnings. The main problem with using trailing earnings to measure valuation is that earnings fluctuate and are generally the highest at market tops and the lowest near market bottoms. The best way to illustrate this problem is to look at recent history. On March 1st of 2007, the S&P traded with a 16.92 P/E ratio and on March 1st of 2009 it traded with a 110.37 P/E. Clearly in spite of the valuations based on trailing earnings, stocks were a better buy in 2009.

I prefer to use the Shiller P/E based on the work of Yale University professor Robert Shiller. The Shiller P/E is a more effective measure of value because it eliminates the variations in profit margins during the business cycle. This allows an investor to have a better idea of when a stock or index is truly cheap. The Shiller P/E compares the inflation adjusted earnings over the previous 10 years to the current market price. Using this method, an investor actually saw what we all intuitively knew, stocks purchased in 2009 were much more attractively valued than those purchased in 2007.

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Currently, the Shiller P/E on the S&P 500 sits at 22.34 and is significantly more expensive than the bulk of the S&P 500's history. As a matter of fact, the current market valuation is more consistent with what has historically been the beginning of a secular bear rather than a secular bull market. These nosebleed valuations do not indicate an imminent market crash, but do indicate an environment where one should expect weaker market returns and greater market volatility.

Economic Data

Despite what at least on the surface appeared to be a relatively solid US employment report on Friday, the global economy is clearly weakening. Europe is beyond a train wreck and China is slowing but the popular myth fed to the masses by Wall Street's sell side analysts is that the United States is magically decoupling and will continue along a path of slow and steady growth. Have you ever heard the stock pushers tell you that the economy was actually bad and suggest exiting the stock market? Even in 2008? Of course not, if you are not buying stocks, they are not making money. You hear, "Buy and hold," "There is always a bull market somewhere," or now "The US stock market is still the best house in a bad neighborhood." Well as my realtor says, "You should never buy any house in a bad neighborhood." Generally the analysis we get comes from people who need you to buy stocks in order to put food on the table. That clearly creates what is generally a poorly disclosed conflict of interest.

So let's grab a shovel and dig a little deeper into this decoupling myth. If this myth is true, we should not see true signs of the US slowing.

Let's start with one of my favorite indicators of economic health - manufacturing:

The July US ISM Manufacturing PMI Composite index came in 49.8%. This gave us our second consecutive month of manufacturing contraction and the lowest print since July of 2009. A below 50 print does not necessarily indicate recession but does indicate weakness and over the last 15 years moves from the high 50s to a level below 50 have generally preceded significant stock market declines.

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Beyond manufacturing, Let's take a look at the largest portion of the US economy, the consumer through retail sales:

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Retail sales have turned sharply lower since March of this year. We have experienced three consecutive months of declining retail sales for the first time since the fall of 2008. With roughly 70% of the US economy comprised of consumer spending, this is an incredibly concerning trend.

Further, we do not have any indication from leading data that manufacturing, retail sales or any other coincident data will improve in the near term. The Philadelphia Federal Reserves US index of leading economic data has proven to provide a clear path for coincident economic data and the S&P 500 as well.

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Notice that the leading economic data has relentlessly weakened since the fall of 2011 and further that the S&P 500 has diverged from the course projected by the leading data. Translation: things look to be getting worse, but market participants seem to be counting on the Fed and the ECB to put on their superhero capes and come flying to the rescue. Considering that central banks have been around for a long time and have never actually been able to prevent a recession, buyers of stocks at these levels are making a very bold (and I believe very foolish) wager.

Recession may not yet be upon us, but the US economy is not decoupling and clearly slowing with the rest of the world.

Technical data

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The market looks incredibly weak here. We completed a clear five wave move down from 1422 to 1266 and the move up from 1266 appears to be corrective due to the number of overlaps in the wave structure. This seems to indicate that we should have at least another move comprised of fives waves lower from here. Also, while we are seeing higher highs on the S&P 500, we are not seeing new highs in relative strength (RSI) and are actually seeing lower highs in the commodity channel index (CCI). These divergences in indicators in conjunction with weakening volume are generally pretty good signs of a weakening trend. Given the weakening trend and dual overhead resistance, the market seems like it should begin moving lower from here (or near here) with an initial price target of roughly 1239.

Conclusion: This in no way constitutes trading advice and I suggest that you do your own analysis, but given the overvaluation in the S&P 500 (NYSEARCA:SPY), weakening economic data and a chart that seems to indicate lower prices, I will definitely be shorting this pig (along with IWM and QQQ).

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in SPY, IWM, QQQ over the next 72 hours.