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Last Friday, the SPDR S&P 500 ETF (SPY) closed at 358.10—a fresh All-Time High (ATH), topping the prior closing high on September 2 at 356.27. However, that new All-Time High (ATH) was accompanied by concerning signals from some of our proprietary indicators, causing several quantitative models to stand aside from aggressively bullish selections.
(Note: We usually use the S&P 500 as a proxy for market signals because it tracks 80%+ of all market capitalization.)
In some cases, the extremes of these signals have prompted a mandatory 50-50 market exposure in our systematic models, with half of the portfolio invested in an Equity ETF (e.g., SPY or QQQ) and half in a Cash-Proxy ETF (e.g., SHY or BIL). Stocks are also near all-time highs of valuation, which isn't a distinct signal but does weigh negatively on the prospect of higher share prices. This article will provide the details behind the most important risks investors face at this time.
Chart 1 below shows the SPDR S&P 500 ETF (SPY) in a volatile, flag consolidation for the last two months, after reaching an all-time closing high of 356.27 on September 2. Last Friday, the ETF closed higher than its previous high by only 0.51%, closing at 358.10.
Chart 1: The S&P 500 has experienced a sideways consolidation for the last two months. Last Friday, we saw a breakout with SPY finishing 0.51 higher.
Using new All-Time Highs (ATH) as a bullish signal, an inch is usually as good as a mile—that is, it doesn't matter if it's a half a percent or 5%, but this new high for stocks has also reached a level of overvaluation that is itself setting a new ATH. Moreover, by one measure, it's a valuation that's nearly double the late-90s dot-com insanity.
Critical Indicators Reach Extremes
In the long-term, stocks remain in a bull market. However, several key measures indicate—with high probability—that there is potential for a sizable correction over the coming weeks. These indicators recommend a move to 50% cash/cash-proxy ETFs for several of our more conservative strategies that are generally bullish. For example, our NASDAQ Persistent Profits Strategy moved from a 100% long position to a rare, 50-50 exposure using QQQ (Invesco Nasdaq 100 ETF) and SHY (the iShares 1-3-year Treasury Bond ETF), giving it an overall exposure of only about 25%.
The reason for this unusual positioning comes from a unique combination of two indicators—"Percent of Total Shares Above Their 200-day SMA" and "Percent SPY is Above Its 200-day SMA." The first is the percentage of stocks in an index (such as the S&P 500) that are—individually—above their 200-day moving average. This measure is a Breadth Indicator, and in our system, it has the moniker of $BI01. The second measure identifies times when an ETF is at an extreme price significantly above its long-term moving average (200-day SMA).
When either of these indicators reaches an extreme, it means that risk has increased. Historically, when both indicators have reached a simultaneous extreme, it was a high-probability harbinger of an imminent selloff. 'High'—as in 100% probability. In practical terms, this heightened risk is likely the result of the market running out of buyers (i.e., demand)—they have all done their buying, and there are few buyers left to continue bidding up prices.
Chart 2 below shows the SPDR S&P 500 ETF (SPY) in the top window, the A) Percentage of S&P 500 shares Above their 200-day SMA in the middle window, and B) Percent SPY is Above its 200-Day SMA in the bottom pane. In the second pane (#A), it is a high-risk condition when 80% or more shares are above their 200-day Moving Average (400 or more stocks in the S&P 500). The 'sweet spot' for this Breadth Indicator is between 50% and 75%. If fewer than 50% of S&P 500 stocks (250 companies) are not above their 200-day moving average, and if that ratio is not rising, then the market is likely to be weak. Above 80% (400 companies), and prices are getting severely overextended, and savvy investors take profits.
In the bottom window (#B), stocks are at an extreme when the S&P 500 (SPY) is 10% or more above
its 200-day Moving Average. In both cases, extreme price conditions are identified with a red-shaded bar that stretches up to the S&P 500 in the top window. When bars are stretching from both indicators, the overlapping shows a darker-red shading, indicating significantly higher risk. On the far right, we can see that such a situation is occurring right now.
Chart 2: When the two indicators shown above reach coincident extremes, it is cause for caution. Each time this occurred in the past, it was followed by a significant decline.
Chart 3 below shows a 6-month zoom into the above chart (Chart 2). At Friday's close, 83.86% of S&P 500 stocks (#A, middle window, 419 issues) were above their 200-day moving averages. The S&P 500 has also climbed to an extreme level of almost 12% above its 200-day Moving Average (#B, bottom window). These two signals combined has always shown a downturn was imminent. That's not to say there is a 100% probability that stocks will decline—because there is not a 100% probability of anything—but it is a very high probability.
Chart 3: When the two indicators shown above reach coincident extremes, it is cause for caution. Each time this occurred in the past, it was followed by a significant decline.
If share prices of the S&P 500 fall from here, last week will be considered a failed breakout of the two-month consolidation. It's also possible that share prices will rise from here, which is why our models have an overall slightly bullish bias. We are still in a bull market until lower-lows are established on longer-term charts. There is significant support at the bottom of the consolidation channel, so the S&P 500 would have to break through that level for the longer-term trend to turn downward. We should know the answer to this question soon—perhaps in the coming week.
Valuations are at Stratospheric, All-Time Highs
With the US economy and as-reported Corporate Earnings (TTM) continuing to decline while the Fed lowers rates to zero, pumps liquidity, and forces investors to buy equities, it's only logical that prices are reaching new highs and continuing to escalate each quarter. This is causing valuations to become excessively stretched. The Fed has indicated that it is standing down for now, but will it come to the rescue again if there is a selloff? And what about after that? The Fed has driven valuations to all-time highs, and will be forced to stop its manipulation either now or later. The higher it forces prices without a natural deep correction, the worse will be the ultimate outcome.
Today, one valuation measure—the ratio of stocks (Wilshire 5000) to GDP—often called the 'Buffett Indicator' is at all-time highs, far surpassing previous in Q1-2000 and Q3-2007. The industry has coined the term 'Buffett Indicator' because Warren Buffett, the most successful investor of all time, has said that it's his favorite way to determine if stocks are overpriced. Warren must be looking at this indicator with the same amazement we have.
The Buffett Indicator today has attained the discomforting level of 2.01, nearly doubling the 1.18 reading in 2000 that accompanied the Dot-Com bubble (which ended in disaster for many). Valuation measures are not timing tools because extreme valuations can continue to ever greater extremes. Here is where I'm supposed to quote the old trope, supposedly by John Maynard Keynes; "The market can stay irrational far longer than you can remain solvent." This chestnut remains true... all too true.
Chart 4 below shows the 'Buffett Indicator' since 1970, reaching an All-Time High in the third quarter this year.
Chart 4: This chart shows the 'Buffett Indicator,' which compares the Wilshire 5000 Index to US GDP.
Chart 5 below shows the US GDP. The denominator of the Buffett Indicator Ratio displayed above is the US Gross Domestic Product (GDP). That makes the Buffett Indicator a macro version of the Price/Sales Ratio that investors often use to identify undervalued individual stocks. One reason for the incredibly high Buffett Indicator is that GDP fell off a cliff this year (-31.4%) and while it has regained half that loss, it has yet to fully recover. The question is, will it continue to rise, or will it fall further from here?
Chart 5: Gross Domestic Product (GDP) dropped 31.4% in the 2nd quarter. It has recovered half this loss, but the economy's direction remains unclear.
Overvaluation Confirmation
Our friends at AdvisorPerspectives.com track four additional valuation indicators, including the 1) Crestmont P/E, 2) Cyclical P/E 10, and the 3) Q Ratio compared to their Arithmetic Mean, as well as the 4) S&P 500 compared to its Regression Line. They then combine and average these four ratios to build an Average Valuation Composite. From there, they compare the current level of this average to its long-term mean.
Chart 6 below shows the Advisor Perspectives' Four Valuation Indicator Average is near the same level it reached during the Dot-Com Bubble madness in the late-1990s. At 147% above its long-term mean, that was the most stretched prices have ever attained since 1900—until now. The current reading is at 141% above the mean, and if prices continue higher, it will surely surpass the old record. If prices continue any higher at all, it could set a new record—and potentially be the setup for another devastating period. On the other hand, will the Fed resume pumping money (QE) at these nosebleed levels, forcing institutional investors to continue buying?
Chart 6: This average of four well-known valuation indicators shows that the market is currently near the same level it reached before the Dot-Com crash.
Courtesy of AdvisorPerspectives.com.
Covid Pandemic
The United States is facing significant challenges ahead. The primary driver of those challenges, overarching everything else, is the global COVID-19 pandemic, which has hit the US harder than most countries because the US has yet to develop a plan to deal with the disease. There's nearly a quarter-of-a-million Americans dead, and there's still no plan from Washington. That is supposed to change in the next couple of months with the new administation, but the impact of pretending that Coronavirus doesn't exist during its first 10 months could bring the US economy to its knees before things get better.
Chart 6: The third wave of COVID-19 cases is hitting the US particularly hard at this time. Source: OurWorldInData.com.
Economic conditions will likely begin to improve beginning next summer when a vaccine begins widespread distribution. Of course, the stock market is already anticipating that recovery, but it may have discounted optimum conditions and is probably prone to a sharp correction if there are any disappointments.
Recession Probabilities
The Smoothed Recession Probabilities Index for the US is created using a dynamic-factor Markov-switching model applied to four monthly coincident variables: non-farm payroll employment, the index of industrial production, real personal income excluding transfer payments, and real manufacturing and trade sales.
Chart 7 below shows the Smoothed Recession Probabilities Index for the US from 1970 to the present. We display the S&P 500 in the background. It appears that the US is entering into a double-dip recession, even before any new steps are taken to mitigate the pandemic. There was a half-recovery in the summer, but now the probability of a recession is back to near-100%. For a clearer look at the double-dip aspect of this data that's occurring now, see the original chart on the Federal Reserve's website. However, it doesn't show the S&P 500 for comparison: https://fred.stlouisfed.org/series/RECPROUSM156N#0
Chart 7: US Recession Probability is near 100% today. Will stock prices plummet? What if the Federal Reserve intervenes? And what if the Fed stands aside?
We do not use this particular series in our models for the same reason we do not use valuations: it doesn't correlate well with week-to-week changes in stock prices. For example, looking closely at the right side of the chart, you can see the -35% selloff in March occurred before this indicator began to rise, as the stock market anticipated the pandemic. However, we show these indicators to expose readers to some of the factors facing investors in the future.
Conclusion
Stock prices, as tracked by the S&P 500 index, are at an All-Time High. Those prices are severely stretched above their long-term averages and in nose-bleed territory. How much higher can prices go when they are already far above their average, valuations are incredibly high, economic fundamentals predict a double-dip recession? Also, the Fed has stated that it has no plans for further intervention. Partisan politics is putting the kibosh on another round of Covid relief funds?
It's for these reasons, identified by two of the indicators we use and shown in Charts 2 and 3 above, that our models are holding conservative positions at this time. Overall, our models are about 50% in cash or cash-proxy ETFs. They are predicting there is a high probability of a decline in prices. This decline may not begin on Monday and may not take place immediately. There is a possibility it won't occur at all. Still, with so many aspects we discussed above stacked against the market, how likely is it we'll see much higher prices—and aggressively long positions are appropriate?