In my previous article published on April 4th, I mentioned about a possible average decline of 10-15% in the stock market. The worst decline I mentioned was a 35% plunge in the Russell 2000 (NYSEARCA:IWM). I pointed out a potential head and shoulders pattern forming with targets for the Dow (NYSEARCA:DIA), S&P 500 (NYSEARCA:SPY), NASDAQ (NASDAQ:NDAQ), and Russell 2000 at 18,250, 2,100, 4,450, and 885 in 3-4 months, 3-4 months, 7-8 months, and 8-9 months respectively. At 1 month, it is too early to tell if prices would reach the above targets, but the head and shoulders pattern does not appear to be forming as predicted. Instead, a descending triangle in the Dow and S&P 500 and a triple bottom in the NASDAQ and Russell 2000 has formed. The Trump Rally also seems to have hit resistance. And valuation measures, political risks, and geopolitical conflicts warn of a potential market decline.
The Dow has a price target of 21,100 in 8 days or less. If the index peaks around 21,100, a bearish double top would form, and the new target would be 19,700 in about 2-3 months, a decline of 6.2%. Note that the target is above the 200 day moving average, which was close to the market bottom around the election. The W%R is close to overbought, while the RSI is also close to overbought.
The S&P 500 has a price target of 2,415 in 8 days or less. If the index peaks around 2,400, a bearish double top would form, and the new target would be 2,260 in about 2-3 months, a decline of 6.4%. Note that the target is above the 200 day moving average, which was the market bottom around the election. The W%R is overbought, while the RSI is close to overbought.
The NASDAQ has a price target of 6,070, but the index has already hit that target. The 6-month technicals do not give any downward target, but based on the Dow and S&P 500, somewhere around the 200 day moving average in 2-3 months could be an acceptable target if the index does decline. The 200 day moving average was close to the market bottom around the election. The W%R is overbought, while the RSI is also overbought.
The Russell 2000 has a price target of 1,438 in 1-2 months. If the index peaks around 2,400, a bearish double top would form, and the new target would be 1,280 in about 2-3 months, a decline of 10.7%. Note that the target is below the 200 day moving average, which was the market bottom around the election. The W%R is close to overbought, while the RSI is also close to overbought.
Valuation-wise, the market seems overbought with S&P 500's PE ratio at 25.22. Other than the Tech Bubble and Credit Crisis, the last time the PE ratio was that high was around 1895. The U.S. underwent a serious economic depression from 1893-1897, which included massive bank failure, large gold buying, and a big decline in the stock market. Partial blame for the panic was the 1890 protectionist McKinley Tariff, which "raised the average duty on imports to almost 50%." The S&P Composite peaked at 5.61 in January of 1893, and hit bottom at 3.81 in August of 1896, a decline of 32%. The composite did not hit 5.61 until December of 1898.
Source: S&P PE Ratio
The Shiller PE ratio also shows that the market appears to be overvalued. The ratio is currently 29.29, and it was about 30 on Black Tuesday. The only other time it was higher was during the Tech Bubble. In September of 1929, stocks started to slowly fall. On October 29, Black Tuesday, stocks crashed 23%. The entire crash lasted about 2 years and 8 months and wiped out 89% off the stock market. Possible causes of the Crash of 1929 include margin buying, Fed tightening, and the fact that many people thought stocks were overvalued. Newly elected President Hoover even said that stocks were overvalued. Interestingly, President Trump said, "We are in a big, fat, ugly bubble" during his first campaign debate in September.
Source: S&P Shiller PE Ratio
On Friday, April 28, first quarter GDP growth came out at a disappointing 0.7% annualized rate. But the Atlanta Fed estimated 0.2% growth for the first quarter, while the New York Fed estimated 2.7% growth for the first quarter. So I think the low GDP reading should have been expected. Based on the graph of the U.S. GDP growth rate, the rate may hit negative very soon. And Former Merrill Lynch chief economist and strategist David Rosenberg warned that year-over-year nominal GDP growth hit the lowest level since World War II.
Source: U.S. GDP growth rate 1947-2017
Friday's GDP report "showed the slowest first quarter for household spending since 2009." That is bad news as consumer spending drives the economy. In the months of February and March, monthly personal spending growth fell to 0.0%. Monthly personal spending growth was 0.0% only three times since 2010:
- November and December of 2011 - Maximum market drop was 9.9%.
- December of 2013 - Maximum market drop was 1.7%.
- March of 2016 - Maximum market rise was 3.7%
Since the 2011 period was the only two consecutive months of 0.0% monthly growth, it is possible that the market could decline 9.9%.
Source: U.S. personal spending 2007-2017
On the political front, Congress agreed on a $1 trillion spending deal on Sunday to keep the government open till October 1. But the bill still needs to be voted on in the House and the Senate and signed by the President by Friday. The good news is that there is now less risk of the nation's credit rating being lowered again. The bad news is that $1 trillion will be added to the nation's current $19.9 trillion in debt, which may cause credit rating agencies to lower the nation's credit anyway. This would be a hard bill for Trump to sign, especially since it does not include funding for the border wall. But he will probably sign it to avoid a government shutdown.
U.S. debt to GDP is currently at 104.17%, the highest percentage since about 1947. The nation has the 12th highest debt to GDP in the world after Japan (250%), Greece (179%), Lebanon (139%), Italy (133%), Portugal (130%), Jamaica (128%), Cape Verde (123%), Bhutan (119%), Cyprus (108%), Belgium (106%), and Singapore (105%). The list includes Greece, Italy, Portugal, and Cyprus, countries that had bailouts within the last 10 years. In fact, Greece is up for 7 billion euro debt repayment in July, which the IMF appears reluctant to pay. The 2011 European sovereign debt crisis along with slow growth in the U.S. and fears of about both the U.S.'s and France's credit ratings being lowered caused the stock market crash of 2011. In August of 2011, the stock market declined 16.5%.
Source: U.S. debt to GDP 1940-2017
Geopolitical conflicts also risk causing a correction in the markets. Such risks have certainly not been lacking recently, from Russia in Europe and Syria, China in the South China Sea, and North Korea. North Korea seems to be the biggest problem, because the only option may be a strike or a war. The Trump administration recently talked about tightening economic sanctions and pursuing diplomatic measures with allies and regional partners to pressure North Korea to end its nuclear program. But the U.S. has been pressuring North Korea for years and that has not stopped them. More pressure would likely not do any good, and would just convince North Korea that it is justified to pursue nuclear weapons to protect itself.
The U.S. cannot blockade and try to cut off North Korea from creating nuclear weapons. Besides potential black market trading with Pakistan, China, and Russia, North Korea has a large uranium mine that is believed to have an "annual production capability of approximately 10,000 tons of uranium." North Korea also has the centrifuges to enrich uranium. A nuclear bomb requires only about 55 pounds of U-235 or highly enriched uranium, but actual amounts vary depending on the type of bomb. Natural uranium contains 0.7% of the U-235. That calculates to about 3.93 tons of uranium per bomb. Thus, the country seems to have more than what it needs to create a nuclear warhead. It was estimated that North Korea had "enough fissile material for about 20 bombs by the end of 2016."
The administration said that they are prepared to respond if North Korea tests another nuclear warhead or ballistic missile. Well, North Korea test fired a ballistic missile on Friday. Fortunately, the test failed. But what is the response going to be? The administration did say that it has a navy warship in the area that could launch a tomahawk cruise missile strike, probably similar to the navy strike in Syria in early April. And when will it happen? According to experts, Trump has till 2020 to stop North Korea from developing a nuclear ballistic missile that could reach the U.S. So Trump has about 2.5 years.
If Trump does strike North Korea, and war breaks out, what would happen to the stock market? During the Korean War (June 25, 1950 - July 27, 1953), the Dow fell about 5.5% in the first few days of the war before recovering everything it lost in the next two months. Below is a graph and table of how the Dow performed during major wars.
- World War I - Dow fell about 10% in first year.
- World War II - Dow fell about 50% in first year.
- Vietnam War - Dow fell about 20% in two years.
- War on Terror - Dow fell about 20% in two years.
Source: Impact of War on Stock Markets
The average stock market decline is about 14.7%. Interestingly, one of the causes for the Panic of 1893 was protectionism (tariffs). Some of the causes of Black Tuesday were fed tightening and a President that stated the market is in a bubble. The similarities to the present day are shocking. Also, in the Panic of 1893, people fled to gold. I would recommend buying gold (NYSEARCA:GLD) to hedge against such a decline. But I also think accumulating cash to buy stocks at the bottom is a good strategy.
Disclosure: I am/we are long DRD, SBGL.
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.