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Complacency

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Heads Will Eventually Roll

Is the stock market priced for perfection? A friend of mine recently told me his financial advisor recommended he stay the course, touting the stock market's performance during past election years, and discounting the impact of the recent coronavirus on growth estimates.  SARS, as I understand it, is being cited as a historical precedent for a limited decline up to no more than 5%.  Every financial parakeet out there is singing the same tune.      

But when the SARS outbreak happened in 2002, the dotcom bubble had already burst, and the U.S. stock market indices had already suffered a steep decline of 50 to 80 percent (chart 1).  With SARS coinciding with the very late stages of that decline, how much more could stocks have possibly fallen? 

Another example is the 1957 Asian flu outbreak, one of the most significant in recent history.  By August 1957, small outbreaks had already occurred in the U.S., but a vaccine had just been produced.  Interestingly, U.S. stocks had already been in a bear market since August 1956, and by the time it ended in October 1957, the S&P 500 was down 21.63% (chart 2). 

Enter 2020.  U.S. stocks are experiencing one of the longest bull market in history;  In roughly 11 years, the S&P 500 and Nasdaq 100 have gained 500% and 900%, respectively.  While this megatrend seems unshakable, the truth is we live in an utterly different world than that of the mid-20th century;  Back then, post-war U.S. manufacturing was at its peak.  Nowadays, a great deal of our supply chains is located in Asia, specifically China.  Hence, the smallest flutter of a butterfly's wings can send ripples around the globe.

As you may well know, I have been calling for a major top in the U.S. stock market to occur upon the S&P 500 and Nasdaq 100 reaching ~3,400 and ~9,000, respectively.  As depicted in chart 3, the 2018 high and the late-December 2018 low were the third and fourth waves of the massive five-wave bull trend that began in early 2009.  Purely based on technical analysis, upside objectives of 2,800 (S&P 500) and 7,100-7,600 (Nasdaq Composite) were first published in 2013, and later revised up on the back of the 2015-2016 correction.  My recent work (chart 4), however, focusing primarily on the shorter timeframes (i.e., late-December 2018 to present, and early-October 2019 to present), allowed me to set a tighter objective of ~3461-63 for the S&P 500 ($SPX), and possibly up to 3,499-3,510 according to the S&P futures ($ES).  As of this afternoon, a cup-and-handle breakout appears to have its sights set on the mid-to-high 34,00's (chart 5).  We’ll see how it goes.  In the end, technical analysis is the art of getting a read on the fundamentals by examining the price charts, and I'll attempt to reconcile the two further below.  But before I do, take a look at chart 6 in which the $SPXEW/$SPX ratio is depicted.  For the last couple of years, the equal-weighted index has been underperforming the cap-weighted benchmark.  Can this breadth measure continue to deteriorate as the benchmark steadily claws its way to new highs?        

Chart 7 below is a spreadsheet in which I capture the daily highs and closes of the S&P 500 for the last 10 years, along with the 12-month trailing EPS (real earnings) and the forward estimates for 2020 and 2021.  Below are my observations:           

1.  A historical average P/E of 19.4 to 20, multiplied by the current 12-month trailing EPS of 138ish, puts the S&P 500's “fair value” somewhere between 2761 and 2678.   

2. This year's forward estimate (in green) is 162.33.  Again, based on a historical average P/E of 19.4 to 20, the S&P 500 would be somewhere between 3149 and 3246 today.  This explains the recent decline to ~3215 on January 31st.   

3. Next year's earnings estimate (in red) stands at 173.06.  Using the same historical average P/E of 19.4 to 20, next year's S&P 500 price is estimated to be 3,357 to 3,461.  Interestingly, the futures contract reached 3,357.75 this past Thursday before succumbing to selling pressures.  As for the upper end of next year's price range, namely, 3461, it's clearly in line with the fifth-wave projection depicted in chart 4 again.

In summary, the S&P 500 has already priced in most of next year's earnings, let alone this year's, ignoring any headwinds that could pose a threat to global growth.  Should the weight of the coronavirus tip the economy into a technical recession, the gains achieved since the June 2019 low would most likely be erased (mean reversion to fair value).  

As a final thought, a market willing to downplay the potential threat of the coronavirus by citing historical precedents is a complacent market, let alone the political risk of discounting the possibility of a new 2021 administration with socialistic views.

 

Good trading,

Peter 

 

Chart 1. https://www.61point8.com/Portals/0/article%20images/2020/20200209/20200209NDX1.png

Chart 2. https://www.61point8.com/Portals/0/article%20images/2020/20200209/bullbearmarkets.jpg

Chart 3. https://www.61point8.com/Portals/0/article%20images/2020/20200210/20200210SPX4.png

Chart 4. https://www.61point8.com/Portals/0/article%20images/2020/20200208/20200208ES1.png

Chart 5. https://www.61point8.com/Portals/0/article%20images/2020/20200210/20200210SPX3.png

Chart 6. https://www.61point8.com/Portals/0/article%20images/2020/20200209/20200209SPXBRDTH1.png

Chart 7. https://www.61point8.com/Portals/0/article%20images/2020/20200210/20200210SPXEST1.png

 

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