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Has Something Changed in the Markets?

Has Something Changed in the Markets?

The Markets as of Friday

The S&P 500 was down nearly 10% from it’s January high after another significant selloff on Friday. Eight out of the last ten trading days had been negative. At Friday’s close S&P 500 was down almost 4% in 2018. The NASDAQ was flat in 2018, down 10% from the highs. The Dow Jones was down 5% on the year and 11.6% from the highs.

S&P 500 down nearly 10% from the high at the close on Friday

Gold has looked relatively stronger. The yellow metal was up a modest 2.14% on the year.

With gold holding it’s value and US equity markets in correction territory I was asking myself over the weekend, “is this the start of something bigger?”

Since the lows in 2009 the S&P 500 has made some large drops. From high to low the S&P 500 dropped 17% in 2010. It went down 22% between April and September in 2011. From July of 2015 to February 2016 the S&P dropped 15%. There have also been 10% drops like in the spring of 2012 and fall of 2014.

A 10% correction in and of itself is not a big deal.

But I think when combined with trade war brewing with China, rising interest rates (at least nominally), a $1.3 trillion spending bill and simply being 9 years into a bull market–this could make for the start of a larger selloff into a new bear market.

From a technical perspective this correction has been more violent than previous ones. In the first 18 days of trading in 2018 all but 14 were positive and the S&P 500 rose 7% from 2,682 up to 2,872 only to reverse and over 10 days (only 2 of which were positive) drop down 11.8% to 2,532.

I think it is fair to say that is one of if not the most violent rise and reversal since the 2009 lows.

The 2008-2009 crisis saw a 57% stock market crash. A similar drop from the new high would result wipe out 7 years of gains.

I don’t think the US Federal Reserve will let the markets drop 57%. I think they will cry uncle if there is a 40-50% drop, they will freeze all rate hikes and may even start lower rates again.

Gold and emerging markets should do very well in this environment.

Monday Market Rally

The S&P 500 opened up at 2601 this morning and went up to 2661 and closed near the highs at 2658.

Gold did not sell off however, it actually rose to near the highs of the year.

We’ll see if gold can breech the resistance that has thwarted a larger rally for the yellow metal this year.

As previously mentioned the S&P 500 has dropped like this before. It hasn’t been this rapid before. But given additional negative factors, perhaps most significantly rising interest rates. I believe this could be the start of a larger correction.

I certainly don’t know for sure, if I had a crystal ball I’d be much richer than I am now. But it is important to be diversified in non-correlated alternative investments.

Stocks are Overpriced and Due for a Significant Crash

Despite the pullback over the past few trading days, the S&P 500 is still far beyond the highs during the dot-com bubble and subsequent bust as well as the housing bubble and subsequent great recession.

If the fundamentals supported the S&P 500 at these elevated prices it would be great but the fundamentals do not…these elevated stock prices are one of the faulty wirings running through the global economy.

Up until the last few trading days, using the Shiller PE ratio*, there has only been one time in the history of the S&P 500 when the Price to Earnings level was higher, and that is the peak of the dot-com bubble.

*Price earnings ratio is based on average inflation-adjusted earnings from the previous 10 years, known as the Cyclically Adjusted PE Ratio (CAPE Ratio), Shiller PE Ratio, or PE 10


While imperfect (I tried in vain to find a Price to Free Cashflow chart for the S&P 500), the price to earnings ratio is essentially how much a stock (or in this case the S&P 500 index) costs relative to it’s earnings. A lower PE is better because it means you are paying less for a stream of income.

Price to book is another metric we can look at and the price to book ratio of the S&P 500 is at a level not seen since the 2008 financial crisis.


Netflix: A Specific Example

I want to pick on Netflix as an example of an overvalued stock.

One of the most important metrics for evaluating a company is free cash flow. Earnings can be a little suspect because of accounting gimmicky but it is tough to hide free cash flow numbers. It’s one of my value investing metrics.

Netflix (NFLX) has not had positive free cash flow since twenty-thirteen. In 2016 the free cash flow was in excess of negative $1.5 billion and the trailing twelve month free cash flow amounts to over negative $2 billion.


So they are bleeding money and yet as you can see from the chart above, apart from this last week Netflix stock continues to climb.

What is Causing the Stock Market to Rise?

The United States Federal Reserve has bought bonds to lower interest rates and has also bought other toxic assets (like mortgage backed securities “backed” by mortgages that had defaulted).

In the wake of the 2008 financial crisis the Federal Reserve balance sheet has swollen to over $4 trillion. The chart below shows the Fed’s balance sheet in millions of millions (aka trillion).


This has driven down bond yields and driven up bond prices.

This makes it cheaper to borrow money to buy stocks. It also forces income focused investors to forsake bonds (which have little to negative real yield) and instead pour money into dividend paying stocks.

Companies can also issue bonds at lower rates, and use the proceeds to buy back their own stock.


The Stock Market is Overvalued

Stocks are overvalued and as bubbly as can be due to reckless US Federal Reserve monetary policy. Last Thursday the 8th the stock market closed in correction territory. It rallied back Friday.

I don’t know if this is the start of a larger selloff into a full on bear market or if this will be contained to a correction.

Since the lows of the 2008-2009 financial crisis there have been several corrections and even a 22% drop in 2011. Those were in an ultra accommodative monetary environment and not in a tightening cycle.

This probably *should* be the start of a bear market but the bulls and the Fed might be able to bid the market back up as they have several times before.

I don’t recommend trying to short the market or (if you own stocks) sell. If you know how to time the market I want to get advice from you because I don’t know how to time the markets.

I do know that stocks are overvalued and due for a correction. If the Fed does step in to prop up the markets it will be more negative news for the dollar. The Fed also doesn’t have much room to cut rates and would either have to sit by and do nothing (unlikely) or restart quantitative easing and negative rates.

This should be positive for foreign value stocks and precious metals. From the lows in 2009 the S&P 500 is up 293%. Even if you bought the S&P 500 at the peak of the 2008-2009 bubble you’d be up 80%. The dollar hasn’t tanked so dollar denominated stocks have been a winner. However, if prices and fundamentals mean something, eventually stocks will correct or the dollar will implode. When that happens it will be critical to your financial survival to have alternative investments in place.

This is part 4 of 5 of what I’ve decided to term The Economic Conflagration series where I discuss the faulty wiring pervasive the global economy:

Part 1: A Deadly Electrical Fire you Need to Know About
Part 2: The Real Economy is Weak
Part 3: Crushing Debt in the United States Limits Economic Growth
Part 4: Stocks are Overpriced and Due for a Significant Crash
Part 5: What you can do about it

Part 5 will be release in the coming weeks. Subscribe below to ensure you don’t miss it.