S&P 500:  Update On Risks and Upside Potential. Are We Living In A Different Paradigm?

Let’s have a look at the most bullish markets in the world, the US markets. Not only have they been the leading performers, but they also tend to lead the world up and down.  Right now, world markets are at an impasse, including US markets, but have not broken down into a nasty bear cycle.  It is critical to understand the underlying foundation of both markets and economies and where sentiment is today:

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The question we must always ask at such periods, does it make sense that the cycle could be shifting?  If so, why and what are the risks.  We must always remember that stocks and markets overall can run up much longer and higher than anyone would guess or that they logically should, and they can collapse much further as well.

As of today, the former is the case, as markets have run up despite many reasons they could have collapsed. This includes such things as dysfunctional governments (led by Trump), Brexit, the movement towards trade barriers, record high valuations of markets, wars etc. As we have stated several times, stocks have to go through cycles in both long and short term. This cycle is in its late innings, and some could easily argue that it is in extra innings and could end at any time. Some like Elliott Wave believe that the down cycle has begun.

What is important is understanding the underlying foundation and risks and rewards that it presents. Also, we must closely watch sentiment. What this means is that what drives markets up is money entering it and what kills markets is people selling and pulling money out. Sentiment indicators track this, and when we get to extremes on the upside, there is no more money to enter the market, and we end up seeing a reversal.

On the other side, once markets crash and selling is exhausted, markets find a bottom and start to rise. Remember that at each point market sentiment is at its worst and news from the media is counter to where the markets end up going. When things look the worst, and market analysts and the media are saying things like dyer, markets find a bottom and start moving up. Most do not buy into it, as they are driven by fear and what the masses are doing. People herd and follow each other, which is led by so-called market experts and the media.

So, let’s look at foundational issues and timing tools today, and if we have great opportunities or more risks in place:
First, we have highlighted many sentiment indicators that are at all-time highs. This is not surprising given we are in the longest upcycle both economically and stock market wise in history. The longer cycles run, the more people become bullish, and that includes experts and the average person.

So here is another chart (shown you many in the past) that show the extreme of bullishness in society today:

This chart shows the most diverse US market, the S&P 500 versus the amount of funds in Rydex mutual funds, both bull and bear funds (ratio is the result). Well, we are very close to an all-time high which was hit earlier in the year. Most investors are on the bullish side versus bearish. This is a contrarian indicator, so this is a bearish reflection on stocks.

We want to show you one more indicator in another sector in society.  Here is what corporations are doing:

Well, we have been on a long up rise in corporate buybacks of their shares, with a record hit this year. As you can see, the last time a record was hit was in 2007, just before the greatest crash since the 1929 collapse and Great Depression. Again, a negative indicator. We should also note that buyback has been at high levels since 2010, so it has been a long run of corporate buybacks which have been a major driver of stocks. This is not healthy for the market. You want stocks to go up due to organic reasons, primarily increased revenues. Instead when company’s buyback their shares, the fewer shares trade on the market, which artificially pushes stocks up.

There may be more room for a movement up in some indicators, so we cannot conclude that the market has found a peak, but these are indicators that cannot be ignored.

Now, let’s see how markets have continued up, especially the Tech heavy NASDAQ index. First the major index, the S&P500:

This data was at the end of June, but nothing has changed. This shows that the upside the market has seen this year is completely due to 10 stocks. They do not only account for the total return, but 22% more than the market has performed. This means that without these stocks, the market would be down this year.

This is not healthy for a stock market, and once the movement up in these stocks occurs, risks of a crash increase dramatically. If these stocks were trading at reasonable valuation levels, I would say it is not an issue. But instead, most are trading at nosebleed levels not seen since before the market crashed in the Tech craze in the late 1990’s.  Wide breadth of stocks moving up is needed for a healthy market.

Now the NASDAQ is even worse:

Many are talking about the NASDAQ and how it has done so well.  Well, this chart tells it all. Close to half of the gain for the past 1000 points or 14% move up is due to only four stocks:  Amazon, Apple, Alphabet and Netflix.  That shows little to no breadth in the market. Sometimes headlines can fool investors, and reading how great stocks are, especially the Nasdaq, is not true. Instead, it should show how great only a few stocks have done. If you are not invested in these stocks, chances are you have done poorly and may even be down.

Now let’s have a look at the foundational structure of the markets.  It is important to know that we are now in the longest bull market since WWII. It began on March 9, 2009, and has now gone beyond the great bull of the 1990’s.  Many would say this is great, and yes, it has been, but we all must understand that every bull market ends, and all previous bull markets ended before the duration of this one.

Here is a chart on one highest used valuation tool, the trailing Price Earnings (PE) multiple for the past 12 months:

This chart shows the current 12-month trailing PE ratio to be among the highest in history. One of the reasons is the low-interest rate environment we are in, but that is slowly changing, given Central Banks movement towards raising rates. Now this will be a very slow process, so it should not be a major factor moving forward. But still, we are 71% higher than the median level and basically, the second highest level in history. You must ignore the highest spike up, as that ratio level was due to collapsing earnings, not high stock prices. The one to compare it to is 2000, which yes, was still much higher. That means the market could still run up, but most people look at the 1990’s as an anomaly as that was the first major phase of the technology revolution and many stocks traded up on no earnings or weak earnings. That should not happen again to the same extent it did back then…. but yes, it is possible.

A second indicator we want to look at is total market capitalization to GDP, Warren Buffett’s favourite bubble indicator:

This indicator shows the value of all the companies on the index versus the GDP of the economy.  The current ratio has now reached the peak we saw in 2000. It is once again screaming that we are in bubble territory.  If you look at 2007, it was at much lower levels than we are at today. This is very reflective of the high level of confidence in society today.

But again, this is a warning flag for us and tells us that the risk is significant on the downside, possibly a very large crash.
You will hear that we live in different times, a new paradigm. But I have heard that story before. In 1999, the media and experts were spewing these words out everywhere, saying that this time is different. Well, it was not, and markets crashed by over 50% with technology shares falling by 70%+.

The last indicator is one developed by Professor Robert Shiller. I have shown you this indicator many times. It is the 10-year Price Earnings multiple average or the CAPE (Cyclically adjusted price earnings ratio):

Once again, this valuation is at the 2nd highest level in history. It was only higher at the end of the Technology movement of the 1990’s. It is now much higher than it was before Black Friday, the crash in October 1929, before the Great Depression. Valuations are at nosebleed levels.

So, to conclude, foundationally stock markets are at the end of a long up phase, so on the surface, things look great.  But below the surface, the risks are as great as we have seen in a long time. Valuations are among the highest level we have seen in history. Stocks are driven by only a few companies. Debt which we have not shown in this report continues to be at nosebleed levels in all four sectors:  households, governments, financial firms and non-financial corporations. This is not good, as debt must be paid back. So, when we are in a period of recession, how many companies, individuals and even governments will go bust.

If stocks are expensive, historically we look to bonds. Let’s have a quick look at the bond market:

This is a chart of long-term US treasuries (the perceived safest investment in the world). As you can see, bonds have broken below a resistance line and have seen a huge correction as interest rates have been rising.
As interest rates rise, bond prices fall, and the longer the term of the bond, the greater the movement in price. We have been in a long-term bull market in bonds (falling interest rates) since 1981. The trend appears to be over, and the risk of rising rates is very real.

Historically, rates mainly rise due to inflationary pressures. We do not think that will be the big issue but instead, investors will demand higher returns given the risks of non-repayment is increasing on all debt. When perceived risks increase on debt issuers, investors demand higher rates to compensate for that. That is the trend we believe we are in today, as well as modestly increasing inflation.

So bond performance has not been good. One area that has outperformed is junk bonds:

Again, this reflects the confidence that is out there. Junk bonds have done well whereas high-quality corporate bonds have lost money.  The movement towards junk has been significant, as investors are not even thinking of risks but instead are chasing yield. This is a dangerous phenomenon that will not end well.

The junk bond market is dramatically higher today than it was during the Financial crash of 2007-09. An incredible amount of bonds have been issued. Many are convenient lite, simply meaning there are no assets backing these bonds. It will be a mess when many of these will have to be written off.

Here is how the junk bond market did during the Financial crisis:

They went down 46%, and yes these are bonds.  That is a crash.

So what does an investor do today? Follow our market timing indicators, and do not diverge from what they state you should be doing. Stock market wise, you should be out of China and Europe.

Be out of any junk bond issues, as when they correct, they can do so fast and hard, and you lose liquidity (your ability to sell them).  Make sure your fixed income and bond mutual funds or ETF’s hold no junk bonds.

For investors who want to take a very conservative stance, you still have a window to position yourself. Own short to mid-term bonds and plan on holding them to maturity. They should be Canada’s or AAA corporate bonds. There is nothing wrong with holding cash in high paying accounts. Just make sure they are guaranteed under CDIC.

Do not ignore precious metals: gold, silver and platinum. We think that the opportunity is significant here in the intermediate term. Do not put too much here, but make sure you have some exposure.

GIC rates have been going up but again, make sure you have CDIC coverage. In many of the big banks, you can have $400 to $500k in their bank guaranteed by CDIC as they have different issuers within their mega bank structure. Example, Royal Bank has several subsidiaries who issue GICs including Royal Trust, Royal Bank Mortgage Corp, Securities First Network Bank, RBC Capital Trust etc.  This allows a GIC investor to put a much larger amount in one institution under CDIC.

Watch future reports as other markets are getting closer to a SELL indicator.

Matt Sammut
Chief Investment Strategist