The Dow Set For A Correction

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Includes: DDM, DIA, DOG, DXD, EPS, IVV, LLSP, OTPIX, PSQ, QID, QLD, QQEW, QQQ, QQQE, QQXT, RSP, RWL, RYARX, SDOW, SDS, SFLA, SH, SPDN, SPLX, SPUU, SPXE, SPXL, SPXN, SPXS, SPXT, SPXU, SPXV, SPY, SQQQ, SSO, TALL, TQQQ, UDOW, UDPIX, UPRO, VFINX, VOO
by: David Luo

Summary

The Dow on Friday rallied in the last hour to extend its winning streak to 11 consecutive days.

We're scaling this Wall of Worry in the markets, and we're set for a correction.

Inflation and the weak dollar have been propping up nominal asset prices.

The warning signs parallel those from the 1987 crash, and we should heed those lessons.

Last week, we saw the Dow closing up again to record highs at 20,821.76. After the psychological Dow 20,000 resistance was broken, there's been a huge uptrend. However, I think we're seeing it come to an end. Let's look at what happened Friday. After 10 consecutive up days and new record highs for the DJIA, the pre-markets looked bleak for the markets on Friday last week. During the day, it looked as if the Dow was finally going to end the week down, but, in the last hour of trading Friday, it suddenly eked up a gain. The warning signs are here. We are seeing this rally sputtering, the market is overbought, there are no more bulls pushing the Dow higher, and we're set for a contraction in the market, or at the very least, a pullback.

Weak Dollar and Higher Inflation Cause Nominal Gains in US Equities

When a currency becomes weaker, it takes more of that currency to buy anything. This truth applies to equities, and so even if companies haven't seen real economic growth, their nominal earnings numbers have increased. This leads to nominal gains in earnings while real profits have remained the same. Higher nominal earnings result in higher nominal stock prices, as more investors jump in for capital gains. Thus, the slight weakness of the dollar has been one of the major reasons that the Dow has notched record highs.

Of course, if the dollar becomes weak very quickly, investors will lose confidence in that currency as a good store of value, and will begin to liquidate their dollar holdings and investments, and look for other markets for their money. So it is this delicate balance of having a slowly and steadily weakening dollar, and not a severe decline, that has allowed the Dow to rally to new highs without a corresponding loss in investor confidence. This balance is very difficult to keep, and especially with President Trump's unpredictability, I think the Dow will have to come back down to reality.

Trump believes that the dollar is currently too strong, and has been busy talking down the dollar. He's accused Germany, saying that the euro is "grossly undervalued." So if he thinks the euro is too weak, then means that the dollar is too strong. In fact, we've seen that this hasn't been just talk. Germany has just revealed that China has now become its biggest trading partner, displacing the US for the first time. As we lose in trade around the world, people begin to lose confidence in the dollar, and we will see continued dollar weakness. US political uncertainty at home with the immigration ban, healthcare reform, and what to do about regulations of the financial sector also doesn't help alleviate the tensions of uneasy investors in the US markets.

^DXY Chart

^DXY data by YCharts

The dollar index can be deceiving, because it is measured against a basket of six other currencies. That means that we may have short-term weakness in other currencies that are propping up dollar strength, even amidst long-term dollar weakness. Let's take a look at the dollar versus the Japanese yen, another safe-haven currency.

(Source: DailyFX)

We can see an obvious decline in the dollar's strength versus the yen since the start of 2017. In fact, according to CNBC,

The U.S. dollar fell to a more than two-week low against the Japanese yen on Friday as investors doubted the likelihood of swift tax reform and a quick spending boost from U.S. President Donald Trump's administration.

If we look at another safe haven for investors to flock to, we can talk about gold. The gold price had great week, as I've mentioned before, breaking through the psychological 1244$/oz level, and staged a strong rally. This means that the dollar is weakening versus the gold price, because more dollars are required to buy the same amount of the yellow metal.

(Source: goldprice.org)

The reason the dollar index hasn't fallen anymore than it has is due to the short-term weakness in the pound from concerns over a potential Scottish independence referendum. Investors also harbor fears of the upcoming French election, and the subsequently weaker euro has suppressed the dollar's decline. Once fears in the eurozone subside, we're going to be seeing a much faster decline in the dollar index.

Another concern has been the rise of inflation. To be clear with my definition of inflation, I am using Webster's original 1983 definition that inflation is the increase in the supply of money, rather than the Webster's 2000 definition that inflation is a general increase in prices of goods and services. One effect of inflation is that it may cause an increase in prices. This means, it can also cause an increase in earnings numbers. So inflation, as with a weak dollar, also inflates company earnings, and causes nominal gains in US equities. While we see a gain in our paper wealth, and the nominal value in dollar terms of our equity holdings increase, if each dollar buys less when we liquidate our positions, we haven't really seen an increase in real wealth. The most recent numbers from the BLS show a 2.5% YOY increase in the CPI, way above the Fed's 2% target, and these rate hikes coming from the Fed will definitely be behind the curve.

In fact, we've had higher inflation for a while now, but it's effects have been masked by the strong dollar. When we print more money, normally, the value of the dollar would fall, but with a strong dollar, we've been able to import goods, and export our inflation to our trading partners. We have a huge trade deficit in the US, so that means our trading partners are sitting on hordes of dollars abroad. This has kept a lid on domestic prices. However, now that the dollar is weakening, we're beginning to see the effect on prices of domestic inflation, even in the official statistics.

What isn't helping is that investors don't even believe the Federal Reserve anymore when it comes to coming rate hikes combating inflation. Last year, the Fed told us we would see 4 hikes, and instead we got 1 in the last month of the year. This year, the Fed is telling us to expect 3 hikes. Well, it looks like we will have to wait for the tail end of the year again.

Analysts noted that Federal Reserve meeting minutes released on Wednesday reinforced doubts about a rate hike next month since voting members showed much less urgency to tighten credit.

(Source: CNBC)

Regardless of the hikes, the Fed will no doubt be behind the interest rate curve, and we'll see inflation creeping higher. In the short-term, inflation is good for nominal gains in the market. But once we reach higher levels of inflation, we're going to have the same result as a very weak dollar, a lack of investor confidence, and a subsequent decline in the Dow.

The problem doesn't only involve short-term interest rates, but also long-term interest rates. We're seeing low yields on the 10-year Treasuries. Two Fridays ago, they dropped to 2.42%, and last Friday, they were down to 2.33%. Investors think we aren't going to be seeing hikes from the Fed anytime soon, and the inflation we experience as a result has in part caused these record highs in the market.

Excessive Valuations

There is no doubt in my mind that we are climbing the Wall of Worry. The S&P is trading at a 17.6x P/E multiple. This is the highest this multiple has been in a decade. Of course, the underlying factors causing this overvaluation of companies is the loss of purchasing power of the dollar, which has manifested itself into the market as higher asset prices.

(Source: Investopedia)

(Source: Investopedia)

If we look at the lagging MACD indicator for the S&P and the Dow, it is indicating a bullish trend. However, the leading RSI indicator is signaling a divergence, and showing that the market is overbought. Although technical indicators aren't foolproof, we should consider them as another perspective on market psychology. I'm of the opinion that the market is indeed overbought, but I'll leave you to make your own conclusion on whether to trust the leading or lagging indicator here.

Last Friday we got an 11th straight record close for the Dow. This draws me to parallels seen in 1987, when we saw 12 record closes made by the Dow, before the giddy highs ended with the October stock market crash. In the 1987 crash:

Economic growth had slowed while inflation was rearing its head. There were also some geopolitical issues related to currency disputes between the United States and Germany. The strong dollar was putting pressure on U.S. exports.

The stock market and economy were diverging for the first time in the bull market. Due to this factor, valuation for the stock market climbed to excessive levels, with the price to earnings ratio climbing above 20.

(Source: Investopedia)

Some of the factors that caused the 1987 crash, such as excessive valuations of companies, similar geopolitical problems, currency wars, higher inflation, and higher asset prices without underlying strong economic growth, all look like what we have today. Before the recent dollar weakness, we've even had a strong dollar for years, and this was also the case with the bull market of 1982-1987 before the crash. These warning signs are clear once again; those who don't learn from the past are doomed to repeat it.

Final Thoughts

The markets need a breather at the very least. I think we're going to be seeing a major correction in the markets in general very soon. The Dow and the S&P are coming back down to Earth, it's only a matter of when.

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.

Additional disclosure: I am invested in gold as a hedge against a market downturn. This article is based on public information that I assume to be true and correct. My assumptions and forecast may be wrong. This investment may not be suitable for all investors. Always consider your specific investment goals and styles before investing money.

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