Is A Stock Market Drop Imminent?

Oct.23.12 | About: SPDR S&P (SPY)

Are we on the verge of another nasty stock market drop like this horse and jockey doing a hand-less cartwheel? Possibly. What are some of the clues that it might break and what should you do about it?

The Battle of the Analysts

It is hard to know who to listen to and who to ignore when it comes to analysts spouting off. Technical traders are talking trash, while valuation experts say the market still has game. Fundamental analysts lowered earnings guidance for the market while prices rose, and they are now raising guidance while the market is waffling. Who is right and who is wrong and how should we react to the conflicting views?

Which Market Forces Dictate Direction?

Academics are constantly looking for that one golden rule or ratio that will completely explain everything there is to know about the market. I don't think they will ever find it. Why? Because the market is full of different participants and any one of them might lie relatively dormant for months or years and then suddenly exert their muscles, while the rest of us are wondering where did that come from? Or it could even be that one person that has multiple triggers - some technical, some fundamental and some based on valuation. The approach I like to take is to consider various disciplines and weight more heavily toward the one that demands your attention. If chartists are pointing to a head and shoulders formation while earnings are dipping down slightly but the average stock has a price to earnings ratio of 5 - I'll be buying with both hands! But if the PE ratio is 12 with nothing special on a chart to look at, but forecast earnings fall by 5% for the entire market - I'll be selling. Whichever method is screaming the loudest is the one I will take the strongest signal from. Let's look at a few methods right now to see if we have a signal yelling at the top of its lungs.

S&P 500 Price to Earnings and Trailing Earnings

One of the most common metrics of value is the earnings yield. Below is a chart showing earnings yield since 1999 in the S&P 500 index. You could also use the S&P 500 ETF (NYSEARCA:SPY).

Click to enlarge

If you only consider the earnings yield, it would seem that we are at the higher end of the spectrum making us believe that the market is a decent buy. It's not bad, but we need to remember that earnings fluctuate. If you look at the earnings yield above, it would seem that 2009 was a terrible time to buy since earnings yield was low during this time. What happened? Share prices were down 50% - were they not? What the above chart doesn't show you is that total earnings also fell as the panicking public pinched pennies and temporarily halted the economy. Look below to see the S&P 500 trailing earnings chart:

Click to enlarge

Remember that earnings yield is a function of earnings and share price. If share prices drop 50% but earnings drop 80%, the market will appear to be bad value. Well, it would be bad value if earnings were permanently depressed and never to come back up again. But when fear seizes the masses and spending comes to a screeching halt, how likely is it that this is permanent? Not very likely and this makes the market a good buy despite high valuations following a 50% price drop. But if that is true, is it also possible that when earnings are rapidly hitting historical highs that this is also a signal of unsustainable growth? Yes, if economic growth seems to be accelerating too fast, this also should sound a mental warning that a 'reversion to the mean' could take place.

Profit Margins

While the market has decent value if you compare earnings to share price, it is also true that the earnings may not be able to maintain the pace due to unrealistic projections. Some point to the all time record high profit margins as being another catalyst for falling earnings. Interest rates are being artificially depressed and this is no doubt helping prop up profit margins. But investors typically look forward instead of behind... so when are they going to start forecasting rising interest rates with dropping profit margins and begin pricing this into future earnings and share prices? (Chart compliments of Business Insider)

Click to enlarge

What all this tells me is that despite decent market valuations, earnings and margins are operating at high levels. I prefer to buy when the market has a strong earnings yield and when there is still a lot of upside potential in profit margins and earnings - neither of which is currently present. In fact, there are some reasons to believe that profit margins and total earnings will fall over the next couple of years. But that is a ways off yet. Nonetheless, I don't find the case for market value compelling to force me to buy - but neither does it make this an immediate sell.

Technical Market Action

In the absence of a fundamentally strong buying signal, I turn to price action. Do the charts have much to tell us about investor confidence? First, I want to show you the S&P 500 chart and then we can discuss it in detail. Similar patterns are noticed on the Dow Jones (NYSEARCA:DIA) and NASDAQ (NASDAQ:QQQ).

Click to enlarge

I have added a few lines which I will now describe. First, notice the sloping trendline under the price. Friday's trading made a small puncture in the trend. Will prices bounce up sharply and continue the climb or will they make a significant break downwards over the next week? All eyes will be on this chart over the coming days. Even if this first trendline is broken, it only means the uptrend is exhausted. The market could trade sideways for a while and resume a new uptrend or a downtrend later on. Or it could immediately begin a downward assault. Right now the price is touching the trendline ... so we wait and see.

The horizontal line is a key support level in the 1422 - 1425 range. Why is this so important? Support levels are largely psychological and when broken, investors lose heart and traders come out to capitalize on the fear. This support level was the index peak back in April and was the low on October 12th. These are two reasons why, if prices fall below the 1420 range, investors might throw their hands in the air and sell or even engage in a little short-side speculation. A third reason is that the front-weighted 100 day moving average has been a decent signal as a confirmation of a downward market. In a few days, this front-weighted moving average will also be in the 1420's range. Everything is lining up so that if prices do drop and fall past all three technical triggers, we could see a quick and nasty drop.

One other aspect I would like to draw your eye to... the price action since Sept.

Click to enlarge

Note that the S&P 500 drops followed by a mini-rally that doesn't go higher than the last rally. After this we see another drop that goes a bit lower than the last drop. Lower highs and lower lows is a bad sign. Don't be fooled by the nice slow downward trading ... if this breaks it could really drop hard.

So what should you do? I have a few recommendations:

  • Be wary of small caps
  • Have at least 25% of your position in cash (preferred over bonds right now)
  • Look into some form of dividend growth system, particularly with focus on value (e.g. Dividend Value portfolio)
  • Consider a defensive strategy such as a value-focused utility portfolio (e.g. Defensive Utilities)

Feel free to ask me about any of the portfolios I use in the comments section to navigate these turbulent waters.

Disclosure: I 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. I have no business relationship with any company whose stock is mentioned in this article.