Stock Market Correction Looming

| About: SPDR S&P (SPY)
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Summary

I believe that the stock market is overvalued and will face a correction sooner rather than later.

For one, price/earnings measures are at unsustainable levels and the market will not have the Federal Reserve inflating its prices in the future as it has earlier in this recovery.

Also, the sectors of the stock market that seem to have benefited the most from the historic highs reached over the past weeks are not those that will help growth.

The stock market is near all time highs, and market valuations are stretched.

The S&P 500 12-month trailing price/earnings ratio is just under 21 while the 10-year average for this measure is just under 16.

Robert Shiller's Cyclically Adjusted Price Earnings (CAPE) measure is over 28. The historical mean for CAPE is around 18.

Stock prices usually move in advance of earnings results as investors push prices up in anticipation of the future earnings. The historical results are included because research has indicated that stocks always "revert to the mean" over time.

Thus, in order to justify the high prices, future earnings must go up… or stock prices will fall back.

During the current period of economic recovery, the increases in stock prices have exceeded the increases in earnings as the stock market has been supported by three rounds of quantitative easing that have been produced by the Federal Reserve.

The Federal Reserve is no longer underwriting high stock market prices. In fact, there is a high probability that the Federal Reserve will be draining more reserves from the banking system in 2017 and will be raising its policy rate of interest at least two, if not three, times. Furthermore, the market expects that the value of the US dollar will increase during the year as the Fed raises interest rates.

Second, the economic growth of the economy is not expected to improve that much this year. This is because economic growth is not that strong, the year-over-year growth rate was only 1.7 percent in the third quarter, and it is had to see growth improve dramatically in 2017, especially with a stronger dollar. The Trump economic program has to be formulated and then passed by Congress before in can even be executed. Thus, not much help is coming from here.

In addition, the economic sectors that the stock market expects to do well in 2017 does not seem to be closely connected with improving business capital expenditures and faster economic growth.

The best sector performers in the stock market, year over year, are the Oil & Gas sector and the Telecommunications sector. These are not the real drivers that president-elect Trump seems to be talking about when it comes to discussing economic policy.

Also, the only subsector of these performers that makes the top ten list over this time period is the pipelines subsector of the Oil & Gas classification.

The top performing subsectors come from the Basic Materials sector and it has four of the top five and they are, from top rank to fifth, Coal, Gold Mining, Platinum & Precious Metals, and Mining.

How is this going to drive economic growth?

The biggest comeback, resulting from moves over the past month and one half, is the Financial sector, as the market expects higher interest rates, deregulation, and high trading earnings to drive profits higher.

I have concerns here, however. So much attention is being given to the trading profits banks are going to report in their fourth-quarter earnings, beginning next week, I worry about the quality of earnings.

The business model for successful commercial banks is not driven by trading profits. Commercial banks, to me, have much bigger longer-term issues to deal with than just trading profits.

And, the performance of the Industrials sector is dropping and has been dropping. Some analysts see profits here dropping in the fourth quarter, year over year, not increasing. And, little help in the near term is expected from the Trump administration… the tax cuts will take a little longer to work themselves through the system.

The consumer goods and consumer services sectors are really taking a back seat. These were the sectors that profited the most from the Federal Reserve stimulus and were the backbone of the Obama administration plans. The wealth effect created by the Federal Reserve, however, just did not seem to revive the economy.

The lagging sector is, of course, health care. With the damage that is expected to be done by Congress to the Affordable Health Care Act, even the bouncy markets of the past six weeks cannot keep the health care sector of the stock market in positive numbers.

Given the information provided above, I find it hard for investors to justify the stock market prices and the P/E multiplies that currently exist.

Call be a pessimist in an optimistic world, but I believe that the stock market is living off of a lot of hot air.

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.