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The Approaching Inevitable Market Reversal

Though we're constantly reassured by financial pundits and the Federal Reserve that the stock market is not a bubble and that valuations are fair, there is substantial evidence that suggests the contrary.

The market is dangerously stretched in terms of valuation and sentiment, and it does not accurately reflect fundamentals such as earnings and sales growth.

Why do we care? If we own no stocks in a retirement or other account, we don't care; it's mere background noise. But if we're exposed to the gyrations of the stock market in any way, we should care, because those who sell near the top before the market drops preserve not just their initial capital, but their winnings from the 5+-year bull market. Those who fail to sell risk losing not just their gains, but quite possibly a material chunk of their initial capital.

Another reason to care is that those who bet the market will decline in a trend-reversal profit handsomely, just as those who buy at the bottom of a decline profit handsomely from the trend reversal from down to up.

Let's start with the most fundamental truth: nobody knows the future. If any technique of prognostication worked every time, anyone with three 100% accurate forecasts in a row could turn $5,000 into $100,000 in three trades using options (or futures contracts). A decent rise or drop will triple an option bought before the move:

Image 1

That few manage the apparently simple task of making three accurate predictions in a row (and being confident enough in the technique to leave all the chips on the table) is powerful evidence that no such technique works consistently enough to last even three trades.

That said, the benefits from being correct even once are powerful enough to make it worthwhile to pursue increasing the odds in our favor--even if the odds will never be 100% in our favor.

New Normal: Cycles and TA Banished, or Hubris?

There are three basic tools of prognostication: cycles, technical analysis and fundamental analysis. While each subject is broad, we can boil each down:

  1. Cycles do not presume to predict the causes of trend reversals; they only reflect that such reversals often follow patterns over time. One example is the business cycle, which traces the expansion of credit and risky investments made with borrowed money and the subsequent contraction in credit as bad bets are written off. There are many cycles of varying durations: for example, lunar, solar and Kondratieff cycles.

  2. Technical analysis seeks indicators that presage trend reversals. For example, declining volume and the narrowing of breadth (i.e. a handful of stocks is leading the index higher rather than broad-based participation in the rally) typically presage a breakdown of the rally.

  3. Fundamental analysis holds that the stock market eventually re-aligns with the foundations of corporate valuations: earnings, sales and prospects for future profit expansion or contraction.

In the past six years of unprecedented central bank intervention--quantitative easing (buying of assets such as Treasury bonds and mortgages), zero interest rate policy (ZIRP) and "free money" liquidity (unlimited credit extended to financial institutions and financiers)--the belief that this New Normal is immune to downturns/trend reversal has taken hold, mostly for the reason that every downturn has been reversed by some additional central bank monetary intervention.

If the New Normal is truly permanent, then cycles and technical/fundamental analysis have been mooted: they no longer work because the central banks can push stocks higher essentially forever.

There is another school of thought which holds that central bank intervention so distorts markets that their efforts to eliminate downtrends introduce the seeds of instability which eventually disrupt the market.

Believers in the New Normal hold that the Fed and other central banks have an unlimited ability to print money and buy assets, such that they can buy up the majority of markets to keep valuations elevated.

I see such linear thinking as dangerously simplistic in a non-linear world, and I make the case that the Fed is far more constrained by the bond and currency markets (recall that all these markets are interconnected) than the New Normal faithful believe: The Fed's Hobson's Choice: End QE and Zero-Interest Rates or Destabilize the Dollar and the Treasury Market.

We might also question the basic premise of the New Normal crowd which is that the recent past is an accurate guide to the future. To quote songwriter Jackson Browne: Don't think it won't happen just because it hasn't happened yet.

Though the New Normal faithful see cycles as banished by the godlike powers of central banks, I see a pattern in the New Normal:

DJIA Yearly Chart

Central bank intervention seems to have generated a new cycle: five years of a roaring bull market that reaches bubble heights and then crashes over the following two years.

Is there some reason to believe stocks can loft ever higher, other than central bank intervention?

The one fundamental metric that matters is profits. Let's look at corporate profits and the S&P 500 (SPX):

It appears the stock market is responding to central bank intervention to the degree the interventions have enabled corporate profits to soar. How has intervention boosted profits? One easy way is that by lowering the cost of credit to near-zero, corporations have booked the savings in interest payments as profits.

The question of the N ew Normal boils down to: Can corporate profits continue soaring? Or perhaps more to the point: Can central bank intervention keep pushing profits higher? Since interest rates are already near 0%, the answer seems to be the fruit of QE and ZIRP have already been picked, and there is little more profit to be gained from these policies.

There are a number of reasons to doubt this steep ascent is sustainable, for example, a rise in the U.S. dollar crimping profits earned in other currencies (About Those Forecasts of Eternally Rising Corporate Profits... ), a weakening global economy and the stagnation of real household earnings.

Here is a chart which shows corporate profits have indeed rolled over in the first quarter of 2014:

CP.GDP vs SP 500 (pdc) 2013-12-31)

There are a number of other reasons to suspect the New Normal market is stretched; for example, bearish sentiment is low and bullish sentiment is at multi-year highs:

Corporate after-tax profits as % of GDP

Investors Intelligence Survey Bears + Correction

Other conventional metrics of market activity such as corporate buybacks, mergers and acquisitions, issuance of junk bonds, margin debt, etc. are also at extremes.

A continuance of the New Normal requires these extremes to become even more extreme, with no blowback (unintended consequences) or snapback.

The emergence of inflation is seen by some analysts as a precursor to a market correction:

Countdown to Another Market Peak Has Begun: If we consider two basic drivers of inflation, higher wages and expanding bank credit, there is evidence (via mdbriefing.com) that inflation is systemic:

INVI Bullish Sentiment vs S&P 500

Here's a measure of inflation by good old price:

Wages & Salaries vs Bank Credit % Change (pct) 2014-04-30

The last extreme to consider is volatility, which has slipped to multi-year lows on the complacency born of a belief that central banks can enforce the New Normal of ever-rising markets at will.

Increasing Living Expenses

"Old" VIX Plunges To Record Low (Zero Hedge).

The Big Question: When???

Is the New Normal enforceable even as markets reach extremes, or is the faith in the central banks' power to bend markets to their will just the latest manifestation of hubris?

No one knows at the moment, but as this article has shown, there are numerous persuasive reasons to be skeptical of the New Normal faith that markets can only loft higher in a permanent state of low volatility and rising profits.


In Part 2: The Signal That Will Tell Us A Stock Market Reversal Is Imminent, we present a number of markers that will indicate when the top is in and the uptrend has reversed. The cautious investor will do well to be attentive to these. Remember: locking in gains -- even if that means still leaving some upside on the table -- is vastly preferable than holding too long, and watching those gains evaporate.

Click here to access Part 2 of this report (free executive summary, enrollment required for full access)


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