I find myself writing to you for the second consecutive Friday that brought sharp declines for stocks. These Friday declines bookended a massive rally, which sent the S&P 500 to fresh, all-time highs. It hasn’t been the healthiest rally. It certainly has not been broad-based. Leadership has come from a narrow scope within Tech. Just a handful of stocks have been the growth engine for this stage of the Bull. It feels like a blow-off topping formation. Something needs to change. It just can’t last forever. It has certainly lasted longer than we expected.
We’ve been asked on numerous occasions, and after going through two hyper-inflated Market environments (1999 & 2007), how can we tell if another one is coming? Well, the short answer is we can’t. You never know. But we pay very close attention to the activity below the surface to gauge signs of future price action. The inversion of the yield curve was the important warning sign last year, suggesting stress was building up in the system and growth was slowing. We anticipated a sharp sell-off, which came, but was short-lived. We did not anticipate the Fed getting more aggressive. That cooled the angst in the Bond Market and provided the magic elixir for the Stock Market that it has enjoyed for over a decade.
Investors seem to have discarded the risk of the virus spread and its potential negative impact on the global economy. China’s central bank injected massive liquidity into its financial system to help lubricate economic activity, despite many regions experiencing a forced shutdown. Standard & Poor’s cut China’s GDP forecast for the year to 5% down from the previous 5.75%. JP Morgan cut its estimate to just 1% growth! China’s economy has been slowing for years, but the rate seems to be accelerating. Germany is feeling the hurt again, fighting recessionary pressures. That’s a big deal from the 2nd and 4th largest economies in the world.
Stocks fell again this Friday in the wake of a much better than expected job report for January. More interesting and significant in our minds was the fact that interest rates fell. They didn’t rise. Strong economic growth should be sending the price of money higher. It’s not. The yield curve is on the verge of inverting again. The Bond Market keeps telling a different story than the Stock Market. This had been the best week for stocks since May of last year and there are many characteristics in place similar to 20 years ago. The breakaway Bull Market is getting investors giddy and sending speculative stocks soaring at ludicrous speed.
The rally in 2019 was almost entirely on valuation increase, not earnings, which is the traditional driver of stocks. Earnings were basically flat for the calendar year. Stocks are valued on various multiples, normally on earnings and revenues. You’ve no doubt heard about a Price/Earnings ratio (P/E), which the S&P 500 has historically priced on average around 15.5 times forward earnings estimates. If earnings are growing faster, then a higher multiple often gets applied because investors are willing to pay more for faster growth. That drives up stock prices and the Stock Market as a whole. The flipside is generally true too, as multiples tend to contract when earnings growth slows. That didn’t happen last year. Earnings growth slowed, but the multiple of those earnings actually increased substantially last year, sending stocks to all-time highs. The S&P is trading at nearly 20X earnings, the highest valuation in this Bull cycle, making it the most expensive since 2000. That was just before the Dotcom bubble burst. The explanation in our mind is two-fold. Investors around the globe continued to pour money into the US Stock Market for greater stability and growth, targeting Tech, which has been the dominant sector. But the other force we believe has been the Federal Reserve continuing to inject more liquidity into the financial system, in the form of interest rate cuts and expanding its balance sheet back to Financial Crisis levels when it backstopped the seizing Repo Market last Fall.
The set-up for a blow-off top is here. A blow-off top is a late stage, powerful rally within a short period of time before a major sell-off ensues. Using history as a guide, the Dow has posted a median gain of 13.4% during blow-off tops dating back to 1901. The median rally length was 61 trading days. A similar theme has been in place for the S&P 500, which was formed in the 1950s and is widely considered the US Stock Market.
So are we in the midst of a blow-off top? Well, one rally similar to this one happened between Oct. 15, 1999, and Jan. 14, 2000, just before the Dotcom bubble burst. The S&P rallied 16% in just 64 trading days back then. Another similar rally took place from Aug. 16, 2007, to Oct. 9, 2007, preceding the Financial Crisis. In that time, the S&P jumped 13.3% in just 38 trading days. In case you’re wondering, the S&P just surged 20% since October 3rd. That is 83 trading days, so a slightly longer period with substantially larger gains. The Tech-heavy NASDAQ is up 24% during that time. The October 3 date is significant because it is right around the time when the Fed intervened in the Repo Market. What worries us is the higher it flies, the harder it falls in correction.
There’s nothing like price to change sentiment. Fears have turned to enthusiasm as the rally continued. Investor sentiment is nothing like it was during the Dotcom days, but that probably has more to do with the state of American politics than anything else. Half the country is excited about where things are, while the other half believes we are in a terrible place. But looking under the hood of the Market, there is quite a bit of complacency. The Put/Call ratio indicates there is very little fear and the herd is positioned for much higher gains. History has proven that is the time to be very cautious. It’s the key to Warren Buffett’s philosophy of being greedy when others are fearful, and be fearful when others are greedy.
There’s also the phrase, “this time is different.” We are very afraid of this statement. It has generally used to make a case for why norms are challenged and excesses are ok. It has often been followed by sharp declines. There are many calls for Dow 32K, 40K, and even 50K. These are very radical predictions. They are certainly intentional because they steal headlines and catch people’s attention. They also tend to get people to join the party late just before it ends. So I went back and studied some headlines from 20 years ago to see some of the perspectives in place before the Dotcom bubble burst. Here’s a couple that I found:
Dow 36,000? Why Stop There? Some Wall Street Pundits Say There’s No Limit to How High it Can Go
National Post, Oct. 2, 1999
The Dow has too many stocks whose time has passed
MarketWatch, March 10, 2000
Keep in mind, the Dow was at 10K in October of 1999 when the first article was written six months before the bubble burst. In the second article indicating this time was different, Ralph Acampora, a noted Technical Analyst, said the Tech-heavy NASDAQ, which had just cleared the 5,000 level for the first time ever, looked like it would reach 6,000 by the end of the year. It actually fell almost immediately and didn’t find a bottom until three years later and 80% lower.
We don’t anticipate anything remotely like that happening in the coming months or years. But the massive move higher for many Tech stocks is unsustainable and is ripe for a significant sell-off. The Stock Market stays overbought far longer than oversold. Making money tends to mask underlying problems, until it doesn’t. Big sell-offs tend to be quick and violent. We remember that all too well around the Holidays in 2018. It’s because fear is a much stronger sensation than greed. A natural correction would be very healthy at this stage. There are a great deal of excesses built up in the system. The Fed liquidity is chief among those excesses. Expect more choppy price action ahead.
Have a nice weekend. We’ll be back, dark and early on Monday.