S&P 500 Has Effectively Doubled: It's Make or Break Time for Stocks

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Includes: DIA, QQQ, SPY
by: Erik McCurdy

The S&P 500 index has effectively doubled during the cyclical bull market from early 2009. This type of extreme move is rare and has only occurred a few times during the past 100 years (click to enlarge images):

As a result, valuations have risen to historic highs that are nearly always followed by poor investment returns during the following decade. For example, the cyclically-adjusted P/E (CAPE), which is the ratio of the S&P 500 index to 10-year real earnings, is now approximately 23. The following graph from the Hussman Funds web site displays the long-term view of the CAPE.

Aside from the extremes that accompanied the speculative blow-off rally at the end of the last secular bull market, the current CAPE of 23 places market valuations at the upper end of the historical range within which all previous market cycles had been confined since the late 19th century. Highly reliable forecasting models that approximate subsequent 10-year total returns based on current earnings and dividends indicate that the S&P 500 index is priced to deliver 3.4% during the coming decade, a historically poor return that is rivaled by the current yield on the 10-year Treasury note.

Granted, poor investment merit does not necessarily reflect a similarly bleak speculative outlook and we expect the violent cyclical swings experienced during the past several years to continue until the secular bear market from 2000 enters the final phase of its development later this decade. However, the extreme character of the current cyclical uptrend from March 2009 suggests that it will almost certainly be followed by an equally violent correction; it is simply a question of when. Further, we have entered a critical period in the development of the cyclical bull market and it may be in the process of forming a long-term top right now.

The two intermediate-term cycles following the bottom in August 2009 have exhibited extremely bullish biases as shown on the weekly chart below.

However, the current cycle from March has struggled to break out to a new long-term high and a quick return to the last Intermediate-Term Cycle Low (ITCL) near 1,250 during the next few weeks would indicate the likely transition to a bearish bias and predict the development of the expected correction.

Alternatively, a weekly close well above the previous long-term high near 1,343 would reconfirm the rally and forecast additional gains. Market behavior during the next two to three weeks will indicate which scenario has taken control, and short-term chart analysis has identified the key technical developments that would shift the odds firmly in favor of one outlook or the other.

Short-term cycle analysis has reliably forecast stock market behavior since the long-term uptrend broke down in late February. The sharp decline into the March low was predicted at the beginning of the month, and the S&P 500 index has tracked the scenarios developed shortly after the latest Short-Term Cycle Low (STCL) formed on March 16 almost exactly. The current short-term cycle is at an important inflection point and the next meaningful move will likely signal if the cyclical bull market is in the process of extending or topping.

The rebound off of congestion support in the 1,300 at the end of this week suggests that the Beta Low (BL) has formed and the character of the forthcoming beta phase rally will signal which scenario is unfolding. A strong move up to new long-term highs above the Alpha High (AH) during the next two to three weeks would signal a transition back to a bullish short-term bias and forecast the continuation of the cyclical bull market. Alternatively, a weak reaction or sideways consolidation during the next one to two weeks followed by a move below the BL would favor the long-term topping scenario and predict a quick return to the last STCL.

At this point, both scenarios are viable, but there are several developments that currently favor the topping scenario. First, a negative divergence has formed between technical indicators and price behavior on the daily chart of the S&P 500 index.

Money flow, momentum and price oscillators have all trended lower as stocks returned to long-term highs, indicating a weakening uptrend. Broad market internals such as volume and breadth have also exhibited meaningful deterioration, with both negatively diverging from price behavior since late 2010 before breaking down during the March decline.

Finally, our Sentiment Score has plunged to the lowest level in seven years, reflecting irrationally bullish market sentiment that leaves stocks vulnerable to an abrupt, violent decline.

As always, there are no certainties when it comes to financial market forecasting, only possible scenarios and their associated probabilities. However, the cyclical bull market has reached a point in its development where the two most likely outcomes are clearly delineated and chart analysis provides us with well-defined objectives that will indicate which scenario is unfolding. Charts do not always have an interesting story to tell, but when they do, it is important to pay attention. Market behavior during the next two to three weeks will likely have a meaningful impact on long-term direction, so watch closely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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