Holding steady. The benchmark S&P 500 Index and its white hot compadre the NASDAQ 100 have lately been uncharacteristically moving in a direction other than up. Since peaking on Wednesday, September 2, the S&P 500 has fallen by more than -6% and the tech heavy NASDAQ 100 by -10%. Is this recent stock correction simply fleeting? Or is it the start of a bigger fall as we head into the fall of this most unusual year in 2020?
Oh behave! The performance of both the S&P 500 and the NASDAQ 100 thus far during the recent pullback has been very well behaved from a technical perspective. In many respects, they have been textbook declines. For example, the S&P 500 declined sharply in the three trading days from last Thursday to this Tuesday, only to see the decline come to an immediate halt at its medium-term 50-day moving average support (blue line in the chart below). In the three trading days since, the S&P 500 has been consolidating along this key technical support level.
The same can be said of the NASDAQ 100. After falling with a sharp pace of nearly -12% from last Thursday to this Tuesday, the tech heavy benchmark landed firmly on its 50-day moving average support and has held this key support level on multiple retests in the three trading days since.
This strong stock benchmark resilience at key technical support levels is encouraging that the market will soon find its footing and resume its move to the upside.
A key test for both the S&P 500 and the NASDAQ 100 in the days ahead will be whether they can climb back above their short-term 20-day moving averages (green lines in the charts above), which have served as resistance in the last few trading days.
Five stock market warning signals for fall 2020. Despite the recently orderly market behavior from a technical perspective, the U.S. stock market is not without its ongoing risks. And when looking out over the next two months between now and mid-November when historically some of the most epic stock market corrections have taken place, a number of stock market warning signals are giving me pause.
The following are five stock market warning signals as we move into the fall of 2020.
1. The extraordinary disconnect between stock prices and corporate earnings. Let’s begin by looking back at the U.S. stock market over the past 33 years dating back to 1987. Why 1987 exactly? Because it was in October 1987 in the aftermath of the unprecedented stock market crash that we were first introduced to the “Fed put” that so many stock investors have come to know and love (or disdain depending on your perspective on the merits of direct and relentless government intervention into capital markets) in the decades since.
What we see is that even with the heavy hand of the Fed, U.S. stock prices as measured by the S&P 500 have moved with very high correlation to underlying S&P 500 corporate earnings, which are shown on an annual as reported basis (not adjusted earnings) in the chart above. That is, of course, until the onset of the current health crisis. Since earlier this year, we have seen an unprecedented sharp divergence between stock prices and underlying earnings, with stock prices spiking at the same time that corporate earnings have plunged.
Eventually this extraordinary disconnect will need to resolve itself. Hopefully, it will be corporate earnings that snap back to the upside in a better than “V-shaped” recovery scenario that the stock market has already more than priced in. Unfortunately, both probability, the ongoing evolution of the health crisis, and fundamental reality support an outcome over the next six to eighteen months that is something other than better than perfect.
2. Volatility remains elevated. I might be encouraged that the first outcome could be resolved positively in the coming months if a sense of calm was returning to the U.S. stock market. But it’s not. Instead, investors remain very much on edge. Not only about today, but arguably even more so about the months ahead.
Consider the following chart of the CBOE Volatility Index, also known as the VIX or the “fear” index. In short, the higher the VIX, the greater the “fear” among investors about an adverse market outcome.
Since the onset of the COVID crisis here in the U.S. back in late February, the VIX spiked sharply higher. And while it has come down from its record high levels north of 80 reached in March, it remains elevated above 20 and versus pre-COVID levels despite stocks reaching new all-time highs.
Why does this matter? Consider the last time we saw the VIX remain elevated following a market shock despite the fact that stocks reached new all-time highs. The following is a chart of the VIX from the late 1990s into 2000.
While the VIX was already rising in 1997 with the onset of the Asian financial crisis, it spiked even further amid the Russian ruble crisis and the collapse of Long-Term Capital Management in late summer of 1998. Although the Fed exercised its latest put in resolving the crisis at the time (which now seems so quaint in comparison to the much bigger problems that have arisen since – a repeated cause and effect cycle?), the VIX remained stubbornly elevated above 20 through 1999 and into 2000 despite stocks reaching new all-time highs.
Perhaps history will not repeat itself this time around. But what concerns me in this regard is the following. Consider the chart below of the CBOE S&P 500 6-Month Volatility Index, or the VIX looking out over the next six months, which shows that investors are sustaining a much greater degree of “fear” about what may come in the next six months versus before the onset of the COVID crisis.
In short, this suggests ominous clouds continue to loom heavily on the stock market horizon as we head into the fall and winter.
3. Transports are trailing far behind. A potential reason for investor concern are some of the specific fundamental disconnects that continue to manifest in today’s market. One such deviation is between the S&P 500 and transportation stocks.
Traditionally, transportation stocks have been a useful gauge in either predicting or confirming the direction of the broader market. But over the last two years since September 1998 (remember the stock market correction of 2018 Q4?), transportation stocks have traded effectively flat and have increasingly underperformed the S&P 500 Index. Today, the cumulative performance gap is now over 25 percentage points, which is notably large.
What this suggests is that some of the seeds of the economic weakness that we are now experiencing in 2020 were actually planted well before the onset of the COVID crisis in early 2020. In other words, we were likely headed toward economic slowdown in 2020 even without COVID (albeit to a much smaller magnitude). And the fact that transportation stocks continue to lag far behind suggests that these structural constraints to the economy remain even as markets have stabilized in recent months.
Why does this matter? Consider one of the last times we saw such a dramatic deviation between transports and the S&P 500.
Once again, this took place in the late 1990s at a time when technology, media, and telecom (TMT) stocks were soaring as the rest of the economy and market was slowly grinding away. Eventually this disconnect resolved itself as we all know now, but it was not in a positive way with the reality of transports catching up with the fantasy of tech stocks. Instead, it was the other way around.
4. Top heavy, tech heavy market. Technology stocks taking it squarely on the chin has been a primary driver of the weakness in both the NASDAQ 100 and the S&P 500 in recent days. This has not alleviated the associated complications related to the tech sector.
The problem is the following. The information technology sector makes up an alarmingly large percentage of the S&P 500 Index at this point. When adding back in the selected communications sector stocks that up until recently were included in the information technology sector, it’s weighting is now 34% of the total S&P. This represents a modern all-time high for any sector that was matched only one other time in recent market history. This took place in February 2000, when the tech sector also reached a peak percentage of the S&P 500 at 34%. Of course, both market and technology sector performance over subsequent periods that followed February 2000 were less than stellar.
What is just as much if not more disconcerting is the concentration of S&P 500 weighting in the top ten stocks in the index, as many of these top ten stocks also hail from the tech sector. Consider that the historical average weight of the top ten stocks in the S&P 500 stands at around 19%.
Only once during the “Fed put” era did this top ten weighting spike meaningfully higher than 22%. This took place in 2000, when the top ten stocks peaked at just over 26% of the index and consisted of tech bubble 1.0 high flyers such as Microsoft (MSFT), Cisco Systems (CSCO), Intel (INTC), IBM (IBM) and America Online (now a relatively insignificant part of Verizon (VZ)).
Today, we have seen the top ten weighting in the S&P 500 stretch to previously unreached heights. The top ten stocks now make up 30% of the entire index weighting, which is measurably more than the previous peak. Moreover, the top ten is much more tech concentrated today including Apple (AAPL) and Microsoft (MSFT) alone at nearly 13% of the index and joined by former tech partners Google (GOOG)(GOOGL) and Facebook (FB) as well as technology adjacent consumer discretionary gravity defier Amazon (AMZN).
Maybe these stocks can continue to carry the weight for the rest of the broader market. But the higher they fly while the rest of the market lags, the harder this task will become. And if the recent gains in these stocks have been driven primarily by forces such as the call options shenanigans from the likes of Softbank and retail investors, I become all the more dubious these stocks can keep it up, particularly at valuations that remain historically stretched by most measures including at around 35 times earnings on average.
5. Bullhorn resistance. Since January 2018, the S&P 500 Index has entered into a technical sideways pattern marked by higher highs and lower lows.
Following three failed tests of upside resistance followed by three strong bounces from downside support, the S&P 500 made its fourth attempt last week at breaking out to the upside. So far, the benchmark index appears to be getting pushed back to the downside once again. Perhaps stocks will regain their footing, reverse back to the upside, and finally break out above this nearly three-year bullhorn pattern. But with stocks already at historically high valuations with an underlying economy that remains chronically weak and a global health crisis that continues to rage, this will be a tall order for a market where fundamental gravity would otherwise pull it lower.
The perpetual caveat. Despite these various warning signs heading into fall 2020, the perpetual caveat of which we must remain mindful from an upside risk perspective is the Fed. They have demonstrated that they will stop at nothing to support the U.S. economy and its financial markets, long-term consequences be damned (I can only imagine what the next bubble they help create will look like come 2028, that is of course if they are still around doing the same job by then). Notably, the Fed has actually contracted its overall balance sheet by nearly $160 billion since June 10 including $7 billion in the past week despite its ongoing daily stream of Treasury purchases.
As a result, investors should anticipate that the Fed will quickly get back to its balance sheet expanding ways if stocks fall into an accelerating correction and/or corporate credit spreads start to blow out from already extraordinarily tight levels given the ongoing stream of bankruptcies that continue to flow in week after week. Whether they succeed in reversing the next market correction and what damage is sustained before they do remain to be seen, but investors should resist betting too aggressively against the Fed at least until they are finally defeated in their market rescuing efforts.
Stay long, stay selective, and stay diversified. Investors should stay long stocks despite all of the warning signs outlined above, as they are best served to do so as part of a broad asset allocation strategy. This includes allocations not only to stocks, which are just one of many uncorrelated asset classes capable of generating a positive return at any given point in time, but may also include bonds, precious metals, commodities, currencies, alternatives, and cash.
In the current environment, I continue to favor stocks in more defensive sectors of the market, particularly pharmaceutical stocks in the health care space that offer attractive growth potential at attractive valuations. I also continue to favor value over momentum despite the ongoing outperformance of the latter. While I respect the total return generating ability of the momentum factor, I am more drawn as someone that believes in mean regression over time to the increasingly widening relative return underperformance of the value factor. Beyond stocks, I continue to favor Treasury Inflation Protected Securities, or TIPS, as well as precious metals including both gold and silver at weightings that are reasonable from both a total return and risk control perspective in supporting the broader asset allocation portfolio mix. And I continue to maintain an allocation to long-term Treasuries, although I increasingly recognize that my multi-decade thesis associated with this allocation may have entered its final stages.
Be safe and be careful as we continue into the fall of 2020 and winter of 2021. As for your portfolio, stay long stocks, but emphasize diversification to protect against unexpected downside. For as the five warning signs above highlight, it has the potential to be a volatile final few months of the year for U.S. stocks.
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Disclosure: I am/we are long TLT, TIP, PHYS, PSLV. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long selected individual stocks as part of a broad asset allocation strategy. I am also long SH and RWM as a hedge against these long individual stock allocations.
Disclosure: This article is for information purposes only. There are risks involved with investing including loss of principal. Gerring Capital Partners and Global Macro Research makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made. There is no guarantee that the goals of the strategies discussed by Gerring Capital Partners and Global Macro Research will be met.