The S&P 500 is up by 30% in under 1 year, since its December 2018 bottom.
However, the technical image is starting to look overextended. Also, the VIX divergence is very troubling.
The "Fed Put" appears to be off the table, and the economy as well as the stock market may begin to stall once again.
Many key economic indicators appear to be changing rapidly from month to month, underlining the fragile, and unstable state of the U.S. economy.
There are multiple other factors that suggest the S&P 500 and stocks in general are at or are near a top. Please read on to find out more.
Don’t Get Too Comfortable, A Meltdown Could Occur at Any Moment
The S&P 500 (SP500)/SPX is trading at/or near new all-time highs. In fact, the SPX has surged by a whopping 30% since my “A Significant Rally Could Be Approaching” article was written back on December 24, 2018. Nevertheless, despite the meteoric rise, cracks continue to form in the economic foundation and a significant correction, a mini-meltdown, or even a bear market could occur at any moment.
On February 24, I published an article, “Why Stocks Are Going Higher From Here”. This was when the SPX was at around 2,800, roughly 9% below where it is today. Back then, I used a price target of around 3,200 at which the market could top out. However, given the troubling and inconsistent economic landscape, the correction is likely to arrive sooner than I had anticipated. Furthermore, to exacerbate the situation, the Fed put appears to be back off the table, at least for now.
There are many troubling factors that suggest we may be at or near a top in the S&P 500 and stocks in general. Please read on to find out why.
The S&P 500: Overbought and Overextended
Let’s begin by examining the technical image pertaining to the S&P 500. Despite a plethora of negative news flow, and a substantial number of uncertainties, the SPX has been in a sustainable uptrend for nearly a year now.
S&P 500 1-Year Chart
The RSI is at 70, indicating the likelihood of overbought conditions materializing in the near future. Moreover, other key technical indicators such as the CCI, full stochastic, and others are painting a similar image, akin to a market that is becoming overheated, and is likely to experience a change towards negative momentum soon.
If we are not at a top now, it is possible that this bull stampede could elevate the SPX towards the 3,100-3,150, but I would likely view this as an opportunity to reduce positions, hedge, increase cash holdings, and possibly even short the market.
The VIX Divergence: A Very Troubling Phenomenon
One troubling phenomenon I want to draw your attention to is the VIX, and the apparent divergence we are witnessing in relation to the SPX. Typically, the VIX and the SPX are supposed to move in opposite directions.
VIX 1-Year Chart
As the market/SPX moves higher and makes new highs, the VIX is supposed to move lower or remain at a subdued level. We are not seeing this now. In fact, as the SPX sits at/or near new all-time highs, the VIX is nowhere near its all-time lows.
The VIX closed out the session on Tuesday at 13.10, notably higher than the 12 level we saw just days ago (when the SPX was lower as well), and substantially lower than where we saw the VIX in 2017/early 2018, when it traded below 10, or even 9 at some points.
VIX 3-Year Chart
In fact, despite new all-time highs in the SPX, the VIX is trading around the same level it did at prior short-term market tops throughout the past year. This tells me that investors are nervous, and are buying puts on the S&P 500 to hedge against an upcoming correction, or worse, a mini-meltdown, or possibly even a bear market.
No More Fed Put Equals Trouble for the Market
What is particularly troubling is that the “Fed Put” appears to be off the table. Given that economic indicators paint a picture of an unstable economy (meaning that one month they are showing expansion, the next month contraction, then expansion/contraction again, etc.), I would prefer to see the Fed commit to a sustainable path of easing and monetary base expansion.
Unfortunately, the Fed does not appear ready to commit to such a path. In fact, the odds of another rate reduction in December are at just around 5%; this is compared to around 44% one month ago, quite a huge difference.
Additionally, if we look out further, we see that there is only about a 50/50 chance that the Fed will cut rates at all going out all the way to September 16 of 2020. Thus, the market may not see another rate cut for nearly another year.
Is a Fed funds rate of 1.5-1.75% sufficient to continue to support a stock market rally and sustain an economy on questionable footing? I am not so sure, and the lack of Fed support may turn out to be amongst the main catalysts to deflate asset prices going forward.
Is it possible that the Fed is helping engineer an upcoming recession by putting a stop to its rate cut cycle? I know, “people” say that the Fed is not politicized and has no interest in taking part in the outcome of upcoming political events. However, it is no secret that President Trump, and Fed Chair Jerome Powell have had their differences regarding the path of monetary policy.
Furthermore, listening to people such as former New York Fed President Bill Dudley suggest that the Fed should help sway the election towards a Democratic leader makes me believe more and more that the Fed may be a lot more politicized than it claims.
The Upcoming Election
By the way, the election is coming and things could get ugly in the process. Firstly, the Fed is unlikely to provide any significant support to markets unless the economy and the stock market begin to seriously unravel (like Q4 of last year). Secondly, if a Democratic president begins to appear as a viable option the market could correct or even go into a bear market phase, in my view.
Also, this is not only my view, Paul Tudor Jones and other prominent investors/financiers have expressed similar concerns. For example, Mr. Jones believes the market could have a significant correction if Elizabeth Warren is elected. Paul Tudor Jones recently quoted a possible 25% plunge in the S&P 500 if such a scenario were to materialize.
Corporate Earnings Likely to Worsen
Let’s talk about corporate earnings for a minute. For the most part, corporate earnings have been coming in above consensus estimates for Q3. Nevertheless, some key companies like Google (GOOG) (GOOGL) missed EPS estimates. Please keep in mind that many of the earnings presented have not yet been significantly affected by the U.S./China trade war. In future quarters, the corporate earnings picture could worsen if a comprehensive trade deal is not reached soon. In fact, corporate earnings are already starting to show signs of plateauing, and may begin to worsen further going forward.
China: Deal or No Deal
Pertaining to the China/U.S. trade deal, there are still a lot of unknowns, and it does not seem like anything significant will occur any time soon. Iowa? Greece? It is not even clear when or where the two leaders will meet to hammer out a deal, and even if a deal gets signed it will likely be a largely symbolic occurrence, and is unlikely to significantly improve the state of the U.S. economy.
Economy and its “Transitory Stage”
The U.S. economy appears to be going through a transitory stage, which is not necessarily a good thing. For several months, the U.S. manufacturing base per ISM data was in recession and it is not clear if this trend will improve or continue to deteriorate. ISM non-manufacturing also looked like it was headed towards contraction but the latest 54.7 reading came in better than expected.
The latest nonfarm payroll data also came in better than expected at 128K vs. the expected 89K, but this could be due to the “hangover effect” from last months' worse than expected data. Housing data continues to come in weaker than expected for the most part, and perhaps most troubling is that some key consumer data is now starting to show significant signs of weakness.
For instance, the consumer confidence index CCI, a key leading economic indicator, is at its lowest point since 2014. Moreover, we can see a clear downtrend developing from a top of about 100.9 in the beginning of 2018, to roughly 100 now. This is particularly concerning as the consumer accounts for roughly 70% of U.S. GDP and continued weakness on the consumer side of the economy could tilt the U.S. closer towards a recession quicker than anticipated.
The U.S. “official” unemployment rate ticked up to 3.6% last month. This is still a multi-decade low, but this is not necessarily a positive signal. To the contrary, almost every time we’ve seen the unemployment rate hit a “rock bottom” level it preceded a recession coupled with a bear market in the U.S.
In fact, we see a clear trend that when the unemployment rate bottoms it leads to a recession. We saw this in 2007, 2000, 1990, etc. and we are likely seeing this now.
Stocks are Extremely Expensive
Another factor not to lose sight of is that stocks are extremely expensive on a historical basis. The Shiller P/E Ratio is at 30.36, substantially higher than where it was in 2007/2008, is even above its level from black Monday in 1929, and has only been higher in one other cycle, the dotcom bubble.
The difference is that in the mid- to late 90s we had incredible growth and innovation due to the internet growth phase. Furthermore, the Federal Government even had surpluses in several years. This is much different from our current Federal budget deficit that is over a trillion dollars now.
The point is that there was much more potential for growth in the mid-late 90s than there is now. Therefore, P/E ratios had much more potential for expansion than they do now. If we were to return to a “normalized” (median) Shiller P/E ratio in the SPX of 15.76, the S&P 500 would have to correct by roughly 48%, bringing the S&P 500 all the way back down to about the 1,600 level.
The Bottom Line
This is not an easy market to invest in to put it lightly. This is especially true if you are looking to open new long positions now, as we are probably at or near a short-intermediate term top in SPX and stocks in general.
To sum up:The technical image appears troubling and stocks seem to be approaching an overbought period. To complicate matters, the VIX divergence adds an extra element of bearishness as it implies that the “smart money” is loading up on S&P put options and is preparing for a correction or possibly even a bear market relatively soon.
The “Fed Put” which has been fueling stocks for nearly a year now appears to be off the table, and we are not likely to see more than one more rate cut over the next 12 months. This may change, of course, but only if the economy and the stock market begin to show substantial signs of weakness again. By this time the SPX could be 10-20% lower from where we are now.
The uncertainty surrounding the upcoming election and the possibility of a Democratic President taking over the oval office are also likely to increase volatility, and may cause stocks to correct substantially.
The China/U.S. trade deal continues to be a mirage full of uncertainties, and many unknown factors that could impact economic growth in the U.S. very negatively going forward.
Corporate earnings, although many are better than expected, are based on lowered estimates, and are not showing substantial increases on a YoY basis. Moreover, it is not clear where growth will come from to fuel EPS growth into next year and beyond.
Many economic indicators are sending out mixed signals, are inconsistent, and appear to change drastically month to month. This phenomenon is reminiscent of prior major market tops such as the one seen in 2007/08.
The CCI index is clearly in decline, suggesting the consumer is weakening, and has been since the start of 2018. The rock bottom unemployment rate is also not an encouraging signal as it has preceded just about every recession going back roughly 70 years or so.
Stocks are very expensive right now, and unlike in the mid- to late 90s P/E ratios are not likely to expand due to lack of growth and the enormous amounts of debt, government, consumer, and corporate alike.
Therefore, a correction, a mini-meltdown, or even a bear market could essentially begin at any time. I am looking for the SPX to start to correct now, or between the 3,100 and 3,150 level. I am also looking for a recession to begin within the next 12-18 months.
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Disclosure: I am/we are long VARIOUS STOCKS IN THE S&P 500. 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: This article expresses solely my opinions, is produced for informational purposes only and is not a recommendation to buy or sell any securities. Please always conduct your own research before making any investment decisions.