The stock market has been a charging bull since the beginning of 2016. Over the first six weeks of 2016, selling in the Chinese stock market reverberated around the globe causing the S&P 500 index to decline by 11.5% over a six week period. Since then, there have been few pullbacks. The latest corrective month in equity prices occurred on May 17, but it turned out to be a one-day affair.
Since 2008, central banks around the world, including in the United States, have maintained an accommodative posture. Historically low interest rates have resulted in massive amounts of liquidity flowing around the world. In an attempt to combat the global economic recessionary pressures, monetary authorities dug deep into their tool boxes using interest rate policy and quantitative easing to discourage saving and encourage borrowing and spending. Jumpstarting economic conditions through stimulative monetary policy has created a charge to equity markets as few other assets have offered investors, traders, and other market participants the opportunity for capital growth and yield. Valuations have appreciated to historically high levels, but there has been nothing stopping the U.S. stock market, yet.
Today's highs are tomorrow's lows
Over recent sessions, all three of the major stock indices in the United States have moved to record high levels. The rally in stocks has not been going on for days, weeks, or even months as it is now approaching almost a decade event. Source: CQG
As the monthly chart of the S&P 500 E-Mini futures contract highlights, the rally in stocks commenced back in March 2009 when the futures contract traded to a low of 665.75, and it hit its most recent high of 2,439.75 this month, an increase of over 266% over the past eight years and three months. While there were three pullbacks over the period, the longest correction was five months in 2011, and the most recent lasted only a little over two months at the beginning of 2016. In the world of equities, it has been a case of today's highs are tomorrow's lows for almost a decade.
A one-day correction leads to new all-time peaks
As the daily chart of the E-Mini futures contract illustrates, the selling on May 17 turned out to be a one-day event that took the index from 2,404.50 to lows of 2,344.50 a decline of under 2%, but it wound up fueling the stock market's move to a new record high. There are so many issues around the world that could potentially impact the prices of stocks, but the equity markets have shrugged off any negative news in favor of new peaks. Investors and traders have been trained to buy any weakness in the stock market, and the May 17 move just provided another opportunity to add to positions on the long side. Meanwhile, the U.S. administration remains under fire when it comes to the investigation of Russian influence in the U.S. election. North Korea continues to fire test missiles as it ignores sanctions and international warnings. Terrorist attacks continue to plague Europe with the latest coming in Manchester and London over recent weeks. Long standing alliances in the Middle East broke apart last weekend as Saudi Arabia, and its allies broke off diplomatic relations with Qatar over support for terrorist groups and Iran. In the South China Sea, China continues to expand their sphere of military strength in the region. Russia and the U.S. continue to be at odds over Syria and Iran, and political divisiveness in the United States seems to reach a new high each day. All of these issues add up to the potential of a very volatile and dangerous world. However, stocks have ignored the danger signals on the political landscape, and they continue to grind higher. The volatility index has fallen to historical lows.
The VIX is too low
While the world is a volatile place, there is no sign of the perception of increasing variance when it comes to equity price these days. The VIX rose to highs of 15.59 on May 17, the day of the most recent stock market correction. Meanwhile, as the move to the downside turned out to be nothing more than a one-day wonder, the volatility index has declined back to the 10 level closing on June 8 at 10.24. The current level of the volatility index is the lowest in years, and it comes at a time when valuations for stocks are at historically high levels.
Valuations are too high, and the market is ignoring signs
After an almost decade-long rally, stocks have become very expensive. Source: http://www.multpl.com/shiller-pe/
The CAPE ratio at 29.75 as of June 8, has only been this high twice before since the late 1800s. In the late 1920s when the stock market crashed leading to the Great Depression, stock values were close to current levels and the only other time average price to earnings ratios have been higher was in the late 1990s at the time of the technology bubble that caused a massive correction in equity prices. While stocks could continue to move higher and continue to post new peaks, the air is currently thin when it comes to valuations on a historical basis.
Economics and politics will eventually lead to a much-needed correction
The political landscape around the globe continues to provide many potential pitfalls for the prices of equities. When it comes to economic conditions, there are still more potholes that face stock prices in the days and weeks ahead.
This week, in a sign that the economy in Southern Europe continues to be problematic, Bank Santander purchased the assets of Banco Popular for the price of just one euro. Santander swooped in to buy the bank that was teetering on the edge of insolvency in Spain. While the Spanish economy has faced challenges over recent years, it may be Italy that is the next shoe to drop when it comes to economic issues facing the European Union and ECB. At the same time, Moody's recent downgrade of Chinese debt is a reminder of the slowing growth and economic challenges in the nation with the world's leading economy. In the United States, a weak employment report on June 2 is a sign that the pace of moderate growth may not be picking up to the extent markets had hoped. At the same time, with so many problems on the world stage and issues facing the administration when it comes to Russia and investigations, the President's agenda when it comes to tax reform and infrastructure rebuilding has stalled. The optimism that gripped markets in the wake of last November's election has turned the corner, and many industrial commodities prices have declined significantly from highs in January and February of this year. The President campaigned on a platform that would create vast fiscal stimulus after years of monetary stimulative actions by the central bank. However, President Trump has had a difficult time with his legislative agenda, and the equity markets could run out of patience if it starts to look like tax reform and infrastructure projects become unfulfilled pledges.
Nothing is stopping the stock market from making new highs these days as traders and investors have become myopic buyers. However, peripheral vision tells us that eventually, a correction that begins like the move on May 17 could pick up downside steam and those who are trained to buy any dip will be run over by a freight train of selling that takes valuations back down to rational levels.
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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.