This is the first time in history that the S&P 500 has stretched so far above its valuation norm, leading some to believe that the recent market selloff is a sign of things to come. | Image: Bryan R. Smith / AFP
- Speculation in the stock market could be setting equities up for a significant fall.
- Several downside catalysts are on the horizon.
- The market is trading at historic highs based on valuations; at some point, correction is likely.
The unprecedented nature of the coronavirus pandemic has created an army of investors chanting the same refrain: This time will be different. The stock market’s March selloff, they say, can’t possibly happen again now that the Federal Reserve is pumping untold amounts of cheap credit into the market .
That complacent attitude has become another alarming sign that Thursday and Friday’s declines will snowball into something larger as the month progresses.
Technical Indicators Point to Stock Market Correction
When the stock market crashed in March, many worried that U.S. financial markets were headed for a long-term bear market. But that proved not to be the case when equities pulled off an impressive recovery from April to August.
While technical analysts still concede that the market remains in bull territory, there are some worrying signs that another massive correction is in store.
Bulls point to margin debt—or the amount of money that traders are willing to borrow and trade with—as an indicator of confidence in the stock market’s continued rise. Chief Investment Strategist for RIA Advisors Lance Roberts noted that while this indicates confidence in the market, it’s not an indicator of the market’s direction. Instead, it tells investors how much speculation there is.
Spoiler alert: there’s a ton of speculation right now.
There’s nothing wrong with margin debt climbing higher for the most part— but as we saw back in 2008, and also this March, it tanks the stock market if lenders suddenly call it back in.
Although investors have confidence in the market, that could become a big problem if a downside catalyst causes lenders to start collecting on their debt.
Downside Catalysts
There are a lot of factors threatening to set off a sell-side reaction. Perhaps the most ominous is a financial-sector failure. This time around, banks are much better capitalized than they were back in 2008, which is reassuring. But that doesn’t mean they’re bulletproof. The issue for banks is that they’re taking hits from both sides this time around.
Not only are interest rates at historic lows, weighing on interest income, but loan defaults are expected to rise exponentially over the next few quarters. Last month, the Mortgage Bankers Association reported that 8.22% of outstanding residential property loans were delinquent. That’s up 386 basis points from the previous quarter and represents the largest quarterly rise since 1979 when reporting began.
What’s Next for the Stock Market
No one knows with certainty what’s on tap for the stock market, and so far, the bears have been wrong. But with two days of declines under the market’s belt, it’s worth considering the evidence suggesting this is the start of a larger decline.
First of all, there’s the fact that September tends to be a volatile month for the stock market. Add a contentious presidential election, and large price swings are starting to look more likely.
Next up is the fact that the rally is propped up by just a handful of mega-cap stocks whose valuations have gone stratospheric. Notorious bear John Hussman sees the S&P 500 erasing 66% of its gains by the end of this market cycle. He points extreme valuations as a reason to be cautious :
You know it’s a bubble when you have to edit the Y axis on all of your charts because valuations have broken above every historical peak, and estimated future market returns have fallen beyond the lowest points in history, including 1929
Like the rest of the bears, Hussman believes that eventually, the market will return to its trading norms as it has done for the past 90 years. This is the first time in history that the S&P 500 has stretched so far above its valuation norm, a sign Hussman says is troubling.
Disclaimer: This article represents the author’s opinion and should not be considered investment or trading advice from CCN.com. Unless otherwise noted, the author has no position in any of the securities mentioned.
