US Stock Market Top

Time for another run through the checklist of typical cyclical bull tops in stocks.

1. Market valuation excessive

Second highest market cap to GDP valuation outside of 2000, the 4th highest Q ratio valuation and 4th highest CAPE valuation in history, last two years gains more than 80% multiple expansion and less than 20% earnings growth – CHECK

2. Evidence of overbought and overbullish extremes

II bears highest since 1987, II bulls highest since October 2007, CS Risk Appetite US model into Euphoria; Citi Panic/Euphoria model into Euphoria; Put/Call ratio at extreme low; Second highest ever Skew reading; Greedometer at extreme; Margin Debt at all-time record; Twitter up 80% in a month to a $40bn market cap despite zero profits – CHECK

3. Major distribution days near the highs

In total in 2013 we have had just one major accumulation day and seven major distribution days, which is divergent and atypical for a bull year; We should see further distribution days once the current melt-up breaks – WATCH

4. Rolling over of leading indicators

ECRI WLI is in a downtrend, OECD-derived leading indicators and narrow money point to a topping out at the turn of the year, whilst CB and Markit leading indicators still show strength – MIXED

5. Excessive Inflation

No, we are instead flirting with deflation, in line with demographics trends, which is a potentially bigger threat to a stocks bull but historically atypical. However, commodities remain on the cusp of a potential breakout and a potential typical late cyclical outperformance, whilst the US dollar is potentially flirting with breakdown, which together could provide a short inflation shock; If commodities instead break down, then that should ensure the drop into deflation – WATCH

6. Tightening Of Rates

We see this in the recent sharp rise in treasury yields, touching 3% yesterday; This development is echoed in bond yield rises in both developed and emerging markets globally; Plus China is actively trying to reign in its credit excesses by tightening, which led to the recent cash crunch issues – CHECK

6. Cyclical sectors topping out before the index top and money flow into defensives

This bull market has been dominated by flows into low-beta, dividend paying defensives, which again reflects demographic choices, whilst cyclicals have been more shunned, thus making this indicator less potent – so more N/A

7. Market breadth divergence

We see some breadth divergences in stocks above 200MA in place now for several months, whilst similar divergence in Advance-Declines has been reset by the strong rally of the last two weeks – MIXED

8. A Topping Process/Pattern – I want to focus on this, so:

We see evidence of a ‘blow off top’ pattern. Parabolic shape on the indices long term view. Corrections increasingly shallow. Permabears capitulating and converting to bulls. Perception market can only go in one direction. Euphoria. 

Blow off tops increase the likelihood of a crash, rather than a more leisurely ‘topping process’ range. There are some well known examples from history, and they display a similar technical unfolding to each other.

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Source: Financial-Spread-Betting. Their labelling, but others might recognise the pattern as a kind of wedge-overthrow-top, or a blow off top, where the final rally beyond the consolidation range is the blow-off part, characterised by euphoria and capitulation.

We see a similar pattern unfolded into the Nasdaq’s 2000 peak, and also on the Nikkei’s 1989 top:

27dece4

On a longer term view, we see a parabolic rise and collapse, but it’s in the Daily view action prior to the collapse that we see the clues in the pattern.

The Dow today:

27dece1

The pattern is there, the euphoria is there. A little more breadth divergence would be more compelling, but this could potentially accumulate into the ‘second chance’ point.

So increased chance of a market crash ahead, and if we draw on history again then the combination of a sharp sell-off together with the record high leverage extremes currently in play (margin debt, Rydex), suggest an episode of forced-selling and margin-calls similar to 2008 or 1929, where little will be spared.

Here is the bigger picture for the 1929 crash. Note that all assets sold off together in the crash down to where I have marked a blue circle. After that, gold stocks took off and diverged from the bulk of equities which progressed into a bear market.

27dece5Source: Financial-Spread-Betting

Therefore, although I expect precious metals and miners to return to a bull market as equities top out here, we have to be aware that a market crash could see EVERYTHING sell off due to forced redemptions (1929, 1987, 2008), before PMs can take off in earnest.

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More Red Flags

1. Spike in SP500 Bullish Percent over Put/Call Ratio:

24dece1Source: Stockcharts

2. Spike in Skew:

24dece3Source: J Lyons

3. MACD and RSI divergences versus Dow, courtesy of Karni:

24dece8

4. Parallax SP500 topping signal:

24dece2Source: Larry Footer

5. Greedometer at extreme:

24dece4Source: Greedometer

6. Margin Debt for November at new record high:

24dece5Source: Greedometer

7. Second highest ever short position in treasuries:

24dece6Source: Sentimentrader

8. Corporate profit margins may be rolling over which has been a precursor to a recession in the past:

24dece7Source: Business Insider

9. Spike in China repo rate and Shibor. Liquidity issues in the credit markets (which have ballooned in the last couple of years to 220% of China’s GDP) led to a spike in June and a spike now. China is trying to deflate it again by pumping in liquidity today, but analysts suggest there are danger signs. It is a potential trigger that needs watching. More here: http://www.businessinsider.com/patrick-chovanec-on-the-spike-in-chinese-interbank-rates-2013-12

24dece9Source: Shibor

 

 

 

 

 

2014 For Equities

Dow is up more than 5% five consecutive years now. A sixth such year has not happened before in history. A 5-year bull trend only occurred once before, in the 1990s, and was followed by 3 down years. Russell 2k rallies of similar size and duration to 2013’s (excluding accelerations from major bear lows) are shown below. In each case all the gains were given back the following year.

22dece1

Source: Fat-Pitch

2014 is the second year in the Presidential cycle, and is the weakest historically by returns, averaging flat. The logic for this is that is it a time for governments to deploy tougher, unpopular policies. The Investors Intelligence bull-bear ratio currently exceeding 40% also forecasts a flat return for the SP500 by the end of 2014, by averaging history, whilst the II bear percentage alone, around 15% the last 4 weeks, has historically produced returns of -5% to -20% over the next 6 months.

The Citigroup Panic/Euphoria Model, having crossed the Euphoria threshold, predicts an 83% chance of losses in 2014. Goldman’s analysis of performance following a year of 25% gains or more point to a median drawdown of 11% in the next 12 months.

Next is a chart highlighting a couple of previous occurrences similar to 2012 and 2013 where stock index rises were dominated by multiple expansion, not earnings growth.

22dece3Source: Fat-Pitch

In both instances the following two years saw better earnings growth. But notably the next two years were 1987, stock market crash, and 1999, at the end of which the Dow peaked, suggesting a common theme of pre-correction exuberance.

Both the following charts reveal that 10 year stock market returns are closely correlated to deviations from norms 10 years earlier. The first correlates average investor allocations and the second market cap to GDP. I have added the blue horiztonal line averages, revealing both are overvalued currently, but one more extreme than the other.

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Source: Philosophical Economics22dece5Source: Hussman

The logic behind both is that mean reversion always occurs. The bigger the deviation build the bigger the subsequent normalisation, as ‘this time is different’ each time is disproven. For US markets currently, we see the second highest market cap to GDP valuation outside of 2000, the 4th highest Q ratio valuation and 4th highest CAPE valuation in history. In all the other such historic outliers, a bear market followed to correct the extreme, there was no orderly consolidation of prices whilst the underlying fundamentals accelerated to catch up. ‘This time is different’ thinking argues that because the Fed has suppressed cash and bond yields, equities have to be revalued higher, so this valuation outlier doesn’t count, and there will be an orderly normalisation of valuation as earnings and GDP will accelerate and yields rise slowly, without any crash in equities.

Interesting to discover that the rally in the 1990s was also at the time considered to be Fed-induced and prolonged. Also interesting to find out that the rally in 1980s, where price also accelerated beyond earnings, was achieved in the opposite environment to today where bond yields were record high and twice as high as equity yields at the time. So for no risk, investors could choose bonds at twice the yield, but still went big into equities as they were at historically cheap valuations and were bought up to mean reversion. Today, investors can choose equities at higher yield than bonds, but equities are conversely at historically expensive valuations. No ‘revaluation’ was required in the 80s, so maybe none is required today and equities will be sold down to mean reversion.

Spikes in margin debt and net investor credit balances to extremes have never previously been resolved in an orderly manner, always leading to bear markets or sharp corrections (as in 2011).

20dece4Source: STA Wealth

If ‘this time is different’ we would need to see an orderly reduction in leverage whilst lots of new buyers come to market. But recall through demographics, net investor populations are shrinking across USA, Europe and China, and this is reflected in declining trading volumes.

11dece3We therefore have a gradually thinning investor population, which adds weight to the likelihood of the current leverage excess spike being resolved in the usual historic manner, namely a deep correction or bear market.

However, in the near term, we could yet see more equities allocation and potentially even more leverage. How much higher could equities run before a bear market or a proper correction erupts? I say proper correction, because none of the pullbacks in 2013 have displayed the usual correction characteristics in terms of depth, duration, and flush-out or spike in breadth and vix. They have been shallow pullbacks, with keen buy-up. To this prolonged lack of correction we can add the deviation in distance above the 200MA of the major indices, the excessive bullish sentiment and the current divergences in breadth, and history is fairly compelling in suggesting high risk of a sharp correction. But again, the question is when, and from how much higher?

The 2007 top in US equities was marked by a steeper ascent in the last 12 months of the bull, but this is beaten in steepness by 2013’s rally. In fact, stocks have moved into a parabolic pattern:

20dece12Source: Sy Harding

Parabolic rises are typically resolved in a crash of similar steepness and depth. Comparisons to 1929 are valid if we consider the parabolic ascent, exuberance extremes in valuations, leverage and debt extremes, and a ‘this time is different’ mantra. Where 1929 differs is that it was the culmination of an economic boom with a demographic dividend. The current episode is neither.

History suggests a combination of internals degradation, buyer exhaustion and one or more ‘triggers’ are the likely terminators of a parabolic bull. We see breath divergence, but this should yet degrade further. In a normal topping process, there would be thinnest participation at the final push, but if this is a parabolic top, then we should see increasing divergence as we move higher. There is evidence of buyer exhaustion in sentiment and leverage extremes. We lack the trigger or triggers for the shift in perception. One potential trigger is the earnings season in January, as negative guidance is at a record extreme. A second is that the boost in GDP due to inventory build is likely to be reversed ahead as inventories give-then-take. A third potential trigger is if we see evidence that the current pick up in growth turns out to be a peak in growth rather than a new dawn.

22dece6Source: Moneymovesmarkets

The above chart is derived from OECD’s leading indicators and predicts a peak in industrial output between Dec and Feb.

The case that we are in a new secular bull market for equities relies on growth picking up in a meaningful way from here. For forward earnings calculations to be valid, GDP next year would have to average over 3% for the year and earnings growth come in around 10%. If global growth were to pick up, then we would likely see relative outperformance in emerging market equities and in commodities relative to developed market equities, as both are at relative cheapness to the latter and both are beneficiaries of a growth theme.

However, the history of demographics suggest a sustaining economic revival is unlikely to occur in the foreseeable future. Collective demographic trends in USA, Europe, other developed countries (aside Japan) and China are now both recessionary and deflationary, and we can see that in evidence below:

22dece9

Source: dattaman

22dece10

Source: Yardeni

The only G7 country in a positive inflationary trend is the only G7 country in a curent demographic tailwind window: Japan.

The demographic trends are pretty fixed on a medium term view, and historic evidence suggests that government / central bank intervention cannot force people to borrow or spend. Hence we see continued weakness in bank lending in Europe and the US, and real final sales of domestic product at previous recessionary levels.

5 years after the financial crisis, ZIRP is still in place across most of the developed world, and large QE programmes are still required in USA, UK and Japan. The global economy is fragile, and this puts it risk of rising bond yields and/or commodity price increases snuffing out any pick up in growth, as the former two tend to accompany the latter. The US cannot afford bond yields to rise much further because it would have a detrimental effect on interest sensitive sectors such as housing and autos (and also because of the servicing costs of its ballooning debt), whilst rising commodity prices, particularly energies, are input cost drags on all sectors.

To sum up, from a pure statistical perspective, removing any notion of the bigger picture, the probability for 2014 is at best a flat year for equities with a significant drawdown on the way, and at worst a significant down year. Stats are just a guide, but we see united predictions across a range of measures, drawn together at the top of the page.

However, when we look at similar episodes of stock market rises without earnings growth, similar outliers in stock market valuations to now (market cap to GDP, Q ratio, CAPE), similar historic spikes and extremes in margin debt, and similar extremes in bullish sentiment or euphoria as are currently in place, the same mirrors from history keep cropping up: 1929, 1987, 2000, 2007. Together, these signals point to something more historic and devastating at hand, and the ‘fundamentals’ for that occurring are provided by demographics. Yet the bullish momentum of the market and ‘this time is different’ thinking (Fed trumps all, equities need revaluing due to suppressed bonds and cash yields) are making for widespread complacency about (and dismissal of) the parallels.

Whilst we should not overly rely on any one indicator or discipline, it’s the collective case that gives me such conviction on the short side (disclosure: short stock indices). Now do me a favour and give me a convincing case below for why equities will rise in 2014.

Major Stock Market Top Right Ahead

Second largest and third longest equities bull of the last 80 years, set against an economy that 5-years post crisis is still on life-support. More than 80% of the gains in the last two years have been multiple expansion only, without earnings growth, and the SP500 is on a run of almost 2 years without a 3-week losing streak (the second longest run in the last 40 years – source TheFatPitch).  Impressive, in a perverse way.

Click on the charts to view bigger.

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20dece120dece220dece920dece1320dece1120dece10

 

 

Tower Of Sand

The last two years gains in the SP500 have been mainly through multiple expansion, i.e. just price not earnings:

18dece1Source: Guggenheim Partners

This year, so far, earnings growth has accounted for just 17% of the gains. Digging into that earnings growth, revenues have been weak:

18dece2Source: Yardeni

So companies have boosted earnings-per-share through buybacks, at a rate on par with 2007.

18dece3Source: CNBC

Historically, companies have funded buybacks through borrowing:

18dece4Source: FT

This time is no different.

18dece5Source: NakedCapitalism

October produced a record in corporate debt issuance, and investors have piled in to this market to drive spreads to record lows this year. They have even snapped up the riskier Covenant-Lite corporate debt which offers little protection if the company gets into trouble – to another record level:

18dece6Source: SoberLook

In short, investors have gone all-in on the corporate sector, both in equities and debt. The corporates have used the debt to buy back shares, thus artificially boosting earnings-per-share whilst revenues languish. Even with that, earnings growth has only accounted for 17% of share price rises this year. The rest has been speculation built on the ‘new norm’ of Fed accommodative policy trumps all. Record low debt spreads and historic extreme equity valuations result, and now present high risk to those invested.

Earnings guidance for Q4 (reporting season kicks off in early January) is the most negative on record:

13dece7

Source: Thomson Reuters

The main reason for this is because companies have expected revenues to improve, so cut their guidance for earlier quarters but kept their year end targets in tact. Revenues have failed to materialise and therefore there is a big gap between year end forecasts and actuals, producing that big red bar for Q4 earnings.

Here we can see the persistent theme over the last two years of companies having to lower their quarterly guidance in line with economic reality:

18dece7Source: Bespoke

Of course, in response to lowering guidance analysts then reduce estimates, and with the bar set very low, companies can then peversely exceed estimates and produce a satisfying earnings beat rate, which helps shore up investor confidence. The truth of the meagre earnings and dire revenues becomes distorted.

The bidding up of equity prices without associated earnings growth has produced historic extreme valuations, averaged below:

13dece5

Source: Dshort

I suggest there are 3 secular cycles in the above chart. The 1920s saw an economic boom period with a positive demographic dividend, and by the end of the decade the thinking was that this boom was here to stay, a new norm, which gave rise to the speculative bubble and then collapse in 1929. It was not a new norm after all, and it took around 18 years to wash out excesses, to take valuations to a low enough level from which a new secular bull could erupt.

The 1950s and 60s was another (post war) economic boom period with a positive demographic dividend, and again new norm thinking took valuations to greed levels. The wash out was also around 18 years until valuations were at similar secular bull starting levels (note the demographic dividend was absent in the washout period).

The 1980s and 1990s then provided a third economic boom period with a demographic dividend in the major nations, excepting Japan in the second decade. This concluded with another ‘new norm’ bubble, and dot.com thinking took valuations to an all time exuberance record, and since then I believe we are in a gradual process of washout which should last another few years yet. US demographics peaked around 2000, Europe around 2005 and China around 2010, and we won’t see a collective demographic dividend return until 2020 or beyond. I believe this is why we face a weak economy and a gradual slide into deflation, and central bank intervention can do little to change this. Rather, central bank actions only encourage people into riskier assets by suppressing cash and bond returns, and make the cost of borrowing to do this ultra low. Hence we see another big disconnect now between the stock market and the economy.

Look again at the high outliers in the valuations average chart above: all were the peaks of economic and demographic booms (even 2007 where developing countries contributed a much bigger share to global GDP as China rose towards its demographic and economic peak). In contrast, the current exuberance is set against a weak economy and unprecedented collective demographic headwinds, which I believe makes it the most dangerous outlier yet. The ‘new norm’ this time is the Fed accommodative policy trumps all. It is a bubble.

There are multiple signs that we are reaching the top of this equities bull market (see my recent post Equities Bear Market Coming), and I believe we will see a bear market that will finally produce the washout to low extreme valuations. The negative demogaphic window is set to make this bear a deflationary shock, which means nominal values will have little protection. In other words, stock market falls will be harsh. On these grounds, Russell Napier quotes 400 on the SP500 as a possible bottom. This is maths plus history, not the peddling of fear.

The result would be something like this: a large megaphone with a lower nominal low than 2009:

26nove17Based on margin debt, euphoria, and valuation, the bear market looks set to erupt imminently. That means the Fed would be effectively out of ammo. It has had not the usual opportunity to end stimulus and raise rates to more regular levels, from which it can then ease in the face of a downturn. This should add to the ferocity of the downdraft.

By leading indicators the current window of positive economic data should turn out to be a peak, rather than the global economy finally seeing a new dawn. With commodities finely poised, I do not know whether they will rally as equities top out (in late cyclical style, similar to 2007-8) or break down as demand-supply slack outweighs. If the former, then we would see a temporary inflation until rising commodities help tip the fragile world economy into a deflationary recession. If the latter, then further commodity falls should do the job of completing the slide into outright deflation. Because of the credit excesses again (margin debt, corporate debt), a bear market would likely be unforgiving similar to 2008, i.e. forced liquidation of assets, with few asset classes spared. This time, however, treasury bonds would not seem so safe. Gold has a limited performance history under deflation, but I believe it has potential to be the go-to asset here.

The pretender to the throne, Bitcoin, which temporarily became as valuable as an oz of gold, looks to have burst, whilst gold’s washout looks very similar to 1976:

18dece8Source: Citi

The weak hands have been purged and equities show signs of topping. The next few years are an ideal anti-demographic window for gold to shine, and deliver the dow-gold ratio extreme which we have so far not seen. The question is whether it an escape a downward spiral of forced liquidations.

Similar Solar Cycles And Market Peaks

Here is the progress of current solar cycle 24 overlaid on previous solar cycles of similar amplitude (i.e weak sunspot cycles):

15dece1Source: Solen

Solar cycle 24 is going to be flat-topped, making SC16 and SC14 most similar in progression pattern.

Weaker solar cycles such as these generally produce less geomagnetism (geomagnetism being negative for risk markets), whilst flat-topped elongated peaks could produce a sustained period of sunspot-driven speculation (assuming sustained biological impact on humans). On the flip side, we might presume weaker solar cycles produce less human excitement/speculation overall, although markets history does not suggest so (correlating market manias with solar cycle peaks of differing amplitude).

So, a bit of weekend speculation on my part, but here are solar cycles 14&16:

15dece2 15dece3

The source is Solen.info again and I have added the market peaks.

Solar cycle 22, whilst of bigger amplitude, also had a flat top from 1989-1991, and we saw Japanese stocks peak out in 1989 then Japanese real estate in 1991. Solar cycle 20 was also flat-topped from 1967 to 1970 and we saw various markets peak out in turn in this window (as per my recent Solar Parabolics chart). The Dow’s big bull market into 1929 largely ran from the beginning to the end of the flat solar top. Therefore, I am wondering whether there is something in a flat-topped cycle producing a ‘period’ of human excitement and speculation.

Our current solar cycle, 24, is likely going to look flat-topped from 2011 to 2014 in retrospect. Commodities (by CCI index) peaked in 2011? Equities to peak as we turn into 2014? Both with bumper gains from the lows to the peaks.

I previously focused on the correlation between smoothed solar maximum date and market peak dates, and occasionally there was a notable gap, but this is resolved if the ‘range’ of the solar maximum is considered, rather than just the smoothed peak. There’s also logical appeal of sustained human excitement whilst peak sunspots are sustained. Again, just speculation on my part, but we can expect solar cycle 24’s flat top to end by mid-2014, and I therefore suggest we could see one of two possibities playing out. One, equities peak out within the next 6 months, commodities don’t come again, and we thereafter enter the typical post-solar-peak recession (deflationary). Or, two, equities are peaking now and commodities are breaking upwards out of their large consoliation triangles since 2011 to produce a typical late-cyclical final rally and help tip the weak economy into that recession.

15dece4

Nasdaq

How much more parabolic can the Nasdaq go? I think it’s on borrowed time.

Here’s the biotech sector, which has been a key driver of the index’s outperformance this year, overlaid on the same sector’s performance into 2000:

11dece1You know the dot.com bubble story: ‘regular’ valuations were dismissed and ‘ potential expectations’ became more important than profits. Biotech is largely a sector that always has to be valued on expectations – so the recent rally is speculative, but not (yet) to the craziness degree of 2000.

Another hot Nasdaq sector of late is social media. Twitter up 6% yesterday and valued at $28 billion – yet it has no profits and is not expected to turn a profit until 2015 at the earliest. Facebook is now the 8th biggest Nasdaq company by valuation but trades on a tailing p/e of 128 and a forward p/e of 44 – again ‘justified’ by expectations. Linked In is valued at $28 billion and trades on a trailing p/e of 911 and a forward p/e of 118.

Amazon is the 4th largest Nasdaq company currently by market cap, but trades on a trailing p/e of 1405 and a forward p/e of 144. You get the drift – the same phenomenon as in the dot.com boom is being seen across a range of Nasdaq companies, namely of expectations-driven speculation. But here’s why I think the parabolic is on borrowed time:

11dece3 11dece2Up into 2000 we had a collective positive net investor demographic trend in the major nations aside Japan (first chart), i.e. a steady stream of new investors to the market. These investors then leveraged up to the max (second chart). Demographics also accounted for strong global growth into 2000 and increasing trading volumes.

Here in 2013, we see the same extreme leverage levels have been reached, but demographic trends of this era mean there are a dwindling number of investors, and this is reflected in declining trading volumes. Negative demographics also mean this is a time of meagre economic growth. In short, a shrinking investor population who are ‘all in’ against a poor economic backdrop.

Update

A last chart: the Nasdaq 100 in a tidy bull market channel since 2009 and a rising wedge over the last several months that looks ripe for resolution.

11dece4

Russell 2000

Neglected this parabolic in my recent analysis: the Russell 2000 small cap index.

10dece2Source: Trading View

Now see the p/e valuation, forward and trailing, compared to the Nasdaq and SP500:

10dece3Source: WSJ

And the p/b valuation versus history (and higher now since this 31 Oct read):

10dece4Source: Zero Hedge

80% of this year’s bumper gains in the Russell are accounted for by the rises in p/e and p/b valuations, i.e. earnings have not increased, just price. And by both measures, valuations are historically frothy – unless earnings rise by some ludicrous multiple next year.

This is how the Russell 2000 chart looks on a 12 month view:

10dece5For now, safely in the middle of what is a narrowing channel, but small caps have notably been struggling more the last few weeks relative to large caps.

Disclosure: I am now short the Russell 2000.