The stock market is showing signs of topping out after
its lengthy 5-year run. This is our
takeaway from examining a wide array of factors such as technical condition,
Fed policy, the economy, earnings, valuation and China.
TECHNICAL—The S&P 500 hit an intraday peak of 1883 on
March 7th, and has failed to break higher after numerous
attempts. Trading volume has
consistently been higher on days when the market was down than when it has been
up, indicating a lack of enthusiasm on the buy side and a greater interest in
selling. Recently, stocks have typically
rallied early in the day only to give it all back and more by day’s end.
Momentum stocks featuring sky-high price/earnings ratios or no earnings at all
have been clobbered of late, indicating an increasing aversion to risk. In
recent weeks we have witnessed substantial declines in FireEye (35%), Twitter
(38%), Tesla (27%), Yelp (23%), Workaday (22%) and Netflix (21%). Yesterday (Wednesday) the IPO of highly-
anticipated King Digital Entertainment headed straight down after opening.
Daily new stock highs have diminished rapidly in the last
few months. New highs were running at
about 600 a day in November and only about 200 at the recent market highs. Since mid-February daily upside volume has
trended down at the same time that downside volume has been trending up. The Investor’s Intelligence survey shows
market sentiment at an historical extreme with 55% bullish and only 16%
bearish. The Nasdaq has carved out a
head and shoulders top and dropped below the neckline and its 50-day moving
THE FED AND THE ECONOMY—The Fed has started to withdraw
from Quantitative Easing and, if it stays on the current pace of withdrawal,
will be finished by November. In our
view, this is tantamount to tightening, and is happening at a time when
economic growth has not yet broken free of the constraints emanating from the
aftermath of the credit crisis. GDP was
up only 1.9% in 2013, down from 2.6% a year earlier. Since the recovery began, GDP growth has
averaged a paltry 2% and has not broken out from that range. Although the last half of the year seemed
stronger than the first, most of the growth was attributable to consumer
spending and inventory accumulation. Now the inventories have to be worked off,
while consumer spending depended heavily on a reduced savings rate rather than
income, and is, therefore unsustainable.
Real disposable income increased only 0.8% annualized in the 4th
quarter and was about flat with a year earlier.
In the beginning of the New Year, income, a necessary ingredient for sustainable
consumer spending, is still not picking up.
Furthermore, new orders for core capital goods, a
predictor of future capital spending, have been flat for the last 10 months. Housing, too, remains on the tepid side, with
today’s report showing pending home sales down for the 8th straight
EARNINGS AND VALUATION--At current levels the market is
substantially overvalued by historical precedent. With the S&P 500 closing today at 1849,
the P/E multiple on our calculation of cyclically-smoothed trailing reported earnings
is about 21, far above the long-term historical average of 15, and even further
above typical bear market lows of 7-to-10.
We note that our smoothed estimate is relatively conservative compared
to Robert Shiller’s highly-regarded CAPE multiple of 25.
CHINA—China is facing a slowdown in growth and a
potential credit crisis at the same time.
This puts them in the predicament of possibly having to loosen credit
when prudence would ordinarily call for reining it in. These shorter-term problems also make it more
difficult to follow its desired longer-term policy of increasing the proportion
of domestic consumer spending in the economy.
In addition the accompanying cutback in imports imperils a number of the
world’s emerging economies, thus creating serious headwinds for global growth.
(Please see our comment of March 13th for more on this).
All in all, we think that the odds of a major market
decline are high, and that the upside potential is limited.