As the market races higher, investors should be cautious of a February stock market crash that looks all but certain.
The first week of earnings season was an impressive one, leading both the Dow Jones Industrial Average and the S&P 500 markedly higher. With week two underway, optimism has already started to move the needle higher as Wall Street continue to bet on strong results. But warning signs that a stock market crash is coming have been flashing in the background. Now isn’t the time to be swept up in the wave of bullishness, because it’s about to crash.
A stock market crash may not be in the cards tomorrow, but it could still be on the horizon, some analysts believe. At some point, the market’s beaming optimism will grow cold. No one can be certain of when a stock market correction will take place. Still, there are some indicators that can help put the impressive January rally into perspective.
The S&P 500 surged to record highs this week as investors continue to pour capital into the market. That has pushed more than 80% of the index’s stocks to above their 200-day moving average. On its own, that should give investors pause as it signals overwhelming optimism.
The larger worry, though, is what history tells us. The last time such a large percentage of S&P 500 stocks were trading at these levels was January 2018. After rising to new highs at the end of January, the S&P 500 suffered a pullback of more than 10% in just a matter of days.
It’s also worth noting that a correction is necessary to keep the market from ballooning into a much larger problem. There have been countless warnings about the potential for a stock market bubble, but analysts from JP Morgan Chase & Co say not to worry. They calculate that the S&P 500 would need to make its way above 3,700 to put the stock market at risk.
At the time, they noted that although market performance from 2017-2019 resembles that of a bubble, 2020 would need to produce a year-long surge to produce a true market bubble.
January has produced the beginning of that surge. The S&P 500 gained 100 points over the past month. If that growth rate continues the market will be indisputably in bubble territory well before the end of the year.
Predicting the exact timing of a stock market crash is ultimately impossible, but that doesn’t mean you can’t get a general idea of where stocks are heading. Mark Newton, an independent market technician, is urging his clients to proceed with caution. He says the striking similarities between today’s market and that of January 2018 suggest things will go south sooner than later.
Among other things, Newton pointed to the growing disparity between high yield corporate bonds and investment-grade corporate bonds as reason to worry about the stock market’s short-term future. Newton also noted that measures of market sentiment have also become worrisome:
Markets truly seem to be near exhaustion using traditional methods, but it’s proper to wait on the sidelines until the break gets underway, which should prove swift and severe
Sentiment indicators are a good way to gauge whether market fundamentals are driving a rally. Right now, they’re indicating that today’s market appears to be driven more by emotions than facts. The Ned Davis Trading Sentiment Composite measures whether traders are optimistic or pessimistic about the future. Right now, the measure shows that investors are “excessively optimistic” with a reading of 80. That’s the highest level the composite has hit since June 2018.
Over the past 14 years, the S&P 500 has shed an average of 5% each year following a reading over 62.5.
Ned Davis himself says January can be misleading in terms of market euphoria. That’s because it’s a time of year when a lot of new money generally hits the stock market. But even accounting for pension contributions and beginning of the year excitement, Davis says the current level of optimism among traders should be taken as a warning sign.
Investors tend to be optimistic entering a new year, with lots of inflows to IRA’s and pension plans, but this still shows very high and rising short-term risks.
If no new geopolitical threats crop up and trade talk remains positive, the market could continue to rise through the end of the month. Strong earnings are an important factor for keeping the market afloat. That’s especially true with heavy hitters like Apple (NASDAQ:AAPL), Microsoft (NASDAQ:MSFT) and Amazon (NASDAQ:AMZN) due to report in January.
The backbone of a rally is earnings growth, so if investors continue to believe that fundamentals are catching up to the market’s valuation the rally can continue. If earnings start to turn sour, though, it could set off a major sell-off.
As of this writing, Laura Hoy was long AAPL and AMZN. The opinions expressed in this article do not necessarily reflect the views of CCN.com.
Last modified: September 23, 2020 1:31 PM