Major Stock Selloff Looms

By: Adam Hamilton | Fri, May 9, 2014
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A major selloff is brewing in the lofty US stock markets, which have been grinding sideways for a couple months now. Momentum has faded despite selective positive earnings-season news and Janet Yellen's jawboning. Stocks remain very overvalued, way too expensive for prudent investors to buy. And it's been far too long since their last necessary and healthy correction to rebalance sentiment, so one is seriously overdue.

Last year's extraordinary stock-market levitation has run out of steam. In the 15.7 months leading into early March 2014, the flagship S&P 500 stock index blasted 38.8% higher! Capital indiscriminately flooded into stocks regardless of fundamentals or valuations because the Federal Reserve was doing its darnedest to convince traders that it was effectively backstopping the stock markets. This bred extreme complacency.

Top Fed officials including Ben Bernanke and now Janet Yellen kept implying that the Fed was ready to spin up its monetary printing presses to arrest any meaningful stock-market selloff. So traders greedily bought stocks, ignoring all normal stock-market-topping warning signs. But in the past couple months, this buying has largely vanished. While the S&P 500 has stalled, hyper-overvalued momentum stocks are crumbling.

These growing fissures in the stock markets are on the verge of splitting wide open to shake everything. Since early March the tech-dominated NASDAQ stock index is down 6.7%, with many of 2013's beloved high-flying stocks falling far more. Just as these market darlings had a disproportionate positive broad-market sentiment impact on their way up, they are poisoning general psychology on their way down.

And this troubling divergence isn't happening in a vacuum. The US stock-market valuations remain at very dangerous topping levels. As April waned after the great bulk of the elite S&P 500 component companies had reported their first-quarter profits, that index still traded at incredibly high valuations. On balance corporate earnings barely grew, leaving market price-to-earnings ratios extremely expensive.

On a trailing-twelve-month basis, the average P/Es of the S&P 500 component stocks were running at 22.6x when weighted by their market capitalizations and 25.9x in simple-average terms! This 23x to 26x compares to the century-and-a-quarter fair value in the US stock markets of 14x. 21x marks expensive levels, when stocks rarely enjoy positive returns in the coming years. And over 28x is actually bubble territory.

These exceedingly-risky overvaluations exist at a time when the US stock markets have gone far longer than normal without a 10%+ correction to rebalance sentiment. On average in healthy bulls, these come on the order of once a year or so. The longer stocks advance without some serious selling to slice away the excessive greed and complacency that rising markets breed, the greater the odds of an imminent major selloff.

This first chart looks at the S&P 500's extraordinary Fed-driven levitation over the past year and a half, seen through the lens of the mighty SPY SPDR S&P 500 ETF. Not only is the stock markets' recent stalling out very apparent, but so is the lack of serious selloffs over this time span. If this beloved stock bull is going to even have a chance of continuing higher, it absolutely needs to see a large correction soon.

VIX and SPY Levitation Oct 2012 - May 2014

In broad stock-market terms, selloffs are stratified by magnitude. Anything under 4% on the S&P 500 or SPY doesn't even have a name, it is just normal volatility. Over 4% and selloffs are classified as formal pullbacks. We've seen four of these over the past year and a half or so, but all have been minor. And naturally the efficacy of selloffs for rebalancing sentiment is of course directly proportional to their size.

Big pullbacks approach 10%, at which point they become full-blown corrections. Thanks to the Fed's money printing and jawboning, SPY rocketed an astounding 39.2% higher in just 16.5 months without even a hint of a correction-magnitude selloff. When stocks do nothing but rise, investors quickly forget about their inherent riskiness. So greed and complacency grow out of control, threatening to choke off the bull.

As the next chart reveals a little later, it has actually been a truly mind-boggling 30 months since the end of the last S&P 500 correction! It ended way back in early October 2011. Since then SPY has blasted 71.8% higher at best, with no check on increasingly rampant greedy sentiment. In a normal healthy bull market, we would've seen two or three correction-magnitude selloffs during that time to keep psychology in line.

The problem with excessive greed is it foments major market toppings, bull-slaying events. Greed sucks in all available buying, burning itself out and leaving a vacuum that selling fills. Greed pulls in capital from the sidelines, and greed pulls future buying back into the present. That leaves insufficient buying fuel to keep the bull chugging higher, so it fails. While there's no greed gauge, greed's polar opposite is fear.

And stock-market fear is beautifully approximated by the famous VIX implied-volatility index. While it technically looks at evolving S&P 500 index-options pricing, it effectively measures sentiment. Greed and fear are very asymmetric emotions, the former builds gradually while the latter flares rapidly. So a high VIX shows the widespread fear seen at major stock-market lows, and a low VIX shows the absence of fear.

That's greed, as these two opposing emotions constantly war back in forth in traders' hearts. And greed, revealed by a low VIX, is seen at major stock-market highs. Today's VIX is very low, still down in the 13s this week which is topping territory in historical context. Given this, the rampant overvaluations, and the extraordinarily long time since the last correction, there is zero doubt a correction-magnitude selloff is looming.

But unfortunately speculators and investors have very short memories. After two-and-a-half years without a 10%+ stock-market selloff, the vast majority have forgotten what they are like. In SPY terms, a 10% drop from the recent early-April S&P 500 nominal record highs would drag it back down to $170. That may not sound like much, but those levels were last and first seen in October and August of last year.

So even though the past year-and-a-half's amazing stock-market levitation catapulted SPY 39.2% higher, a mere 10% selloff would erase nearly half of this rally's duration and almost 3/8ths of its entire gains! Think about the wailing and gnashing of teeth in high-flying technology stocks today, and just imagine general psychology if 3/8ths of the recent stock-market run vanished. It would get quite bearish.

Selling and fear feed on themselves, forming a powerful vicious circle. Traders sell, so stocks fall, so fear and bearishness grows, so still more traders sell. And stocks go lower and this cycle keeps renewing itself. So given today's epic greed and euphoria, last year's wildly-anomalous Fed-driven stock levitation, and the super-excessive span since the last full-blown correction, I can't imagine this selloff stopping at 10%.

The longer a bull market goes without critical sentiment-rebalancing corrections, the bigger they need to be to drag psychology back into line. A 15% correction, merely mid-range as far as corrections go, would batter SPY back down near $161. These levels were last seen in late June and first seen in early May. This would lop off well over half of this powerful upleg's entire advance, utterly devastating trader sentiment.

But 15% is really pretty mild after such an abnormal span without corrections, so the odds wildly favor a large specimen approaching 20%. Heck, this cyclical bull's past two corrections which didn't occur in euphoric extremely overbought stock markets ran 16.1% and 19.4% in SPY terms. A totally healthy full-magnitude 20% correction would crush SPY back down near $151. Look at how low that is in the chart above!

$151 was first seen in early February 2013, so a full correction would almost wipe out the entire bull run of the past year and a half or so! Nearly 3/4ths of SPY's entire gains would vanish, and today's younger or newer traders can't even imagine the psychological carnage this would spawn. And if today's cyclical stock bull can stay alive, 20% is certainly enough. Greed would be largely eradicated, with fear and the VIX very high.

But because of today's extraordinary situation, the future viability of this massive bull market is seriously in question. Between March 2009 and April 2014, this stock-market bull as measured by the dominant SPY S&P 500 ETF soared 177.3% higher over 5.1 years! This is far beyond the normal averages of a doubling in just under 3 years. Thanks to the Fed's manipulations, today's bull is far older and bigger than normal.

On top of that we have today's extreme stock-market valuations between 23x to 26x earnings depending on the averaging of the S&P 500 components' individual trailing P/Es. These historically expensive valuations approaching bubble territory coupled with a geriatric bull really challenge the notion that a 20% selloff would be enough. Corrections normally take a few months, not enough time for corporate earnings to materially grow.

So say the overdue correction soon materializes and the S&P 500 is down by 20% a few months from now. At that point valuations will still be high between 18x and 21x, and remember 21x is expensive historically. So powerful arguments can be advanced that instead of a mere bull-market correction, we are now experiencing a bull-market topping that is going to lead to a new cyclical bear market in stocks.

Any selloff over 20% in the S&P 500 is formally classified as a bear. And these rarely stop near 20%. At our current stage in the great third-of-a-century Long Valuation Wave bull-bear cycles, cyclical bears tend to cut stock prices in half. That's right, 50% peak-to-trough declines! This next chart zooms out a bit to show SPY's current massive cyclical bull, and the brutal implications of a new bear market for stocks.

VIX and SPY Cyclical Bull 2009-2014

A 30% decline is mild as far as stock bears go, too common to get excited about. And after SPY rocketed 29.7% higher last year alone thanks to the Fed's money printing and jawboning, a mild bear certainly seems reasonable to rebalance sentiment. But even that would crush SPY down near $132, taking it to levels last seen in mid-2012 and first seen way back in early 2011. Literally years of bull would be wiped out!

A 40% peak-to-trough selloff would leave SPY just above $113, and as you can see that was last seen near the bottom of this bull's last correction in mid-2011 and first seen in early 2010. And a garden-variety cyclical stock bear which cuts stocks in half would leave SPY devastated near $94, levels last seen in mid-2009. A normal full-blown stock bear would eliminate nearly this entire bull run in a couple years!

Between March 2009 and April 2014, SPY climbed almost $121 higher. And a full bear market would erase nearly 4/5ths of those entire gains! This is why it is so unforgivably foolish to be greedy and euphoric when topping signs abound, to buy stocks high rather than buying stocks low. The stock markets are forever cyclical, and investors who naively or brazenly buy into a topping just get slaughtered.

If there is a good chance for a new bear, and there is a high chance right now, it makes no sense at all to buy the vast majority of stocks. It takes many years to recover from 50% losses, and we mortal humans generally only have a few decades of earnings from which to divert surpluses to invest. So the setback from a bear is devastating. And their psychological impact is so great bears force many weaker traders out of stocks forever.

For today's seriously overextended and overvalued US stock markets, the best-case scenario is a full-blown correction approaching 20% emerging soon. And the worst case is a new cyclical bear market that ultimately leads to catastrophic 50% losses. So prudent investors need to be exceptionally careful today, ready to pull out. With this bull running out of steam in recent months despite good news, a topping is likely underway.

Wall Street never calls stock-market toppings, it's bad for business. Professional money managers get euphoric and greedy along with everyone else, and most are surprised by bear markets. So bears are something that always seem exceedingly unlikely when they stealthily begin awakening near major highs when everything seems awesomely bullish. They only gain recognition and acceptance in retrospect.

And ignored topping signs abound these days. In the chart above for example, note the normal bull-market trajectory shown by the yellow dots. Healthy bull markets surge sharply initially out of bear-market lows, but then slow into a horizontal parabola. The Fed's extraordinary money printing and jawboning on backstopping stock markets decoupled SPY from that healthy trajectory just over a year ago.

And without any corrections, the artificial nature of that Fed-driven levitation is glaringly apparent. This bull's first correction started 13.5 months in, and its second correction began another 9.9 months after that first one ended. But we haven't seen a 10%+ correction for 30.0 months now, a crazy span! In market history, long correction-less spans (still shorter than today's) are usually only seen leading into bull toppings.

Even if Wall Street has you so brainwashed that you can totally dismiss the possibility of a new cyclical bear looming, it makes no sense to buy stocks again until we get a major VIX spike. Note that both of the earlier full-blown corrections in this bull catapulted this definitive fear gauge up above 45. Stocks will not be safe to buy again in any way until we see a selloff big enough to propel a VIX spike above 40!

Thankfully major corrections and bear markets are easy to weather. The most obvious way to do it is to sell your overvalued stocks and hold cash. Rather than suffer a devastating 20% to 50% loss, all your capital is preserved so you can buy the stocks you love 20% to 50% cheaper after the selloff. But an even superior option is gold, because major stock selloffs greatly amplify demand for alternative investments.

While few want to remember it today, we've actually suffered two major cyclical bears since the last secular stock bull topped in early 2000. The first cut the S&P 500 by 49.1% leading into late 2002, while the second cascaded into a stock panic ultimately leading to 56.8% losses by early 2009. During those brutal cyclical-stock-bear spans, gold rallied 12.6% and 24.8% respectively! Gold thrives in stock bears.

And when gold is climbing on balance due to growing investor demand, gold stocks tend to soar. This is especially true if their general-stock-bear-market run begins from deeply out of favor and radically-undervalued levels like today's. If a new cyclical stock bear indeed ravages general stocks in the next couple of years, the gold stocks should easily quadruple over that span. Buy cash, gold, and gold stocks.

Imagine quadrupling your investment holdings while general stocks are cut in half. That would give you 8x the purchasing power you have today to buy elite general stocks late in the next cyclical bear paying dividend yields twice as high as today's! Such incredible opportunities to multiply wealth so greatly in such a short period of time are quite rare, and can set up prudent investors for the rest of their lives.

At Zeal we specialize in contrarian investing, buying low when others are afraid then later selling high when others are brave. It's never easy to fight the crowd, to see things coming others refuse to, but the resulting wealth is well worth the social ostracism. Since 2001, all 664 stock trades recommended in our acclaimed subscription newsletters have averaged stellar annualized realized gains of +25.7%!

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The bottom line is the US stock markets are overdue for a major selloff. Absolute best case, this will be a large correction approaching 20%. These are necessary within healthy ongoing bulls to keep sentiment balanced, and thanks to the Fed it has been far too long since the last one. But given how old and large today's cyclical bull is, and how extremely overvalued stocks are, a new cyclical bear is much more likely.

It doesn't take much additional selling late in a major correction to push cumulative losses over 20% into formal bear territory. And cyclical stock bears tend to cut stock markets in half over a couple years. That would wipe out the great majority of the last cyclical bull, and gut the vast majority of traders trapped in it unaware. Thankfully prudent investors can sell expensive stocks, and hold on to the cash or buy gold.

 


 

Adam Hamilton

Author: Adam Hamilton

Adam Hamilton, CPA
Zeal LLC.com

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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