A 20%+ Sell-off is Brewing In the Lofty U.S. Stock Markets – Here’s Why & What the Future Holds (+2K Views)

A major sell-off is brewing in the lofty US stock markets, which have been grinding sideways for a couple months now…Stocks remain very overvalued – way too expensive for prudent investors to buy… [In addition,] it’s been far too long since their last necessary and healthy correction to re-balance sentiment, so one is seriously overdue.

The above are edited excerpts from an article* by Adam Hamilton (zealllc.com) entitled Major Stock Selloff Looms.

The following article is presented by Lorimer Wilson, editor of www.munKNEE.com (Your Key to Making Money!), and the FREE Market Intelligence Report newsletter (sample here; register here) and has been edited, abridged and/or reformatted (some sub-titles and bold/italics emphases) for the sake of clarity and brevity to ensure a fast and easy read. This paragraph must be included in any article re-posting to avoid copyright infringement.

Hamilton goes on to say in further edited excerpts:

“Last year’s extraordinary stock-market levitation has run out of steam. In the 16.5 months leading into April 2014, the flagship S&P 500 stock index blasted 39.2% 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…[speed] up its monetary printing presses to arrest any meaningful stock-market sell-off so traders greedily bought stocks, ignoring all normal stock-market-topping warning signs. In the past couple months, however, this buying has largely vanished. While the S&P 500 has stalled, hyper-overvalued momentum stocks are crumbling, and these growing fissures in the stock markets are on the verge of splitting wide open to shake everything.

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 SPDR S&P 500 ETF (SPY). Not only is the stock markets’ recent stalling out very apparent, but so is the lack of serious sell-offs 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.

…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…comparing to the century-and-a-quarter fair value in the U.S. 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 U.S. stock markets have gone far longer than normal without a 10%+ correction to re-balance 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 sell-off.

In broad stock-market terms, sell-offs 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 sell-offs 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.

The efficacy of sell-offs for re-balancing sentiment is directly proportional to their size. Big pullbacks approach 10%, at which point they become full-blown corrections….When stocks do nothing but rise (like the 39.2% they did in the last 16.5 months without even a hint of a correction-magnitude sell-off) 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, 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 have 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’s polar opposite is fear and stock market fear is beautifully approximated by the famous VIX implied volatility index.

While VIX technically looks at evolving S&P 500 index-options pricing, it effectively measures sentiment. Greed and fear are very asymmetric emotions. Greed builds gradually while fear 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….

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 sell-off is looming.

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…[As such,] 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 the expected necessary correction to re-balance sentiment stopping at 10%. Frankly, even a 15% sell-off [would be] 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!

20% Sell-off

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 [because:]

1. thanks to the Fed’s manipulations, this stock market bull soared 177.3% between March 2009 and April of 2014 which makes today’s bull  far older and bigger than normal –  far beyond the normal averages of a doubling in just under 3 years.
2. 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.

Any sell-off 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.

30% Sell-off

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 re-balance sentiment. A 30% decline would crush SPY down near $132 [see chart above], 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!

40% Sell-off

A 40% peak-to-trough sell-off 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.

50% Sell-off

Corrections normally take a few months, not enough time for corporate earnings to materially grow so, were the overdue correction to materialize soon and the S&P 500 were to go down by 20% a few months from now, valuations would still be between 18x and 21x, and 21x is expensive historically…[As such,]  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.

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!…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.

Conclusion

For today’s seriously overextended and overvalued U.S. stock markets,

• the best-case scenario is a full-blown correction approaching 20% emerging soon.
• the worst case is a new cyclical bear market that ultimately leads to catastrophic 50% losses.

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.”

Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.

*http://zealllc.com/2014/spysell.htm (© Copyright 2000-2014 Zeal LLC All rights reserved)

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