Do Valuations Matter?

In my long career as a passionate follower and participant in the financial markets, technical analysis has always been the driver of my trading and investment decisions. However, every once in a while, the fundamental picture is so clear and compelling that investment action is justified and even demanded.

This may be one of those times! The chart below is borrowed from John Hussman's latest weekly commentary. Mr. Hussman is President of the Hussman Investment Trust and Chief Investment Officer of the Hussman Funds.

This chart represents the Median Price to Revenue Ratio of the S&P 500 Index Components. This ratio is now approximately 40% above the "extreme" level posted at the 2007 stock market peak and about 50% above the overvaluation level posted near the 2000 peak. Historically low interest rates and improved corporate profit margins may explain part of this price expansion, but given the current valuation level in this metric, the bullish case for U.S. stocks from here looks questionable (at best).

While I consider myself a strong student of history when it comes to extraordinary price moves in the financial markets, I've struggled with the rational that is needed now to participate on the long side of this stock market. And despite the fact that my computer trading system has YET to trigger a sell signal, I now have a substantial short position in the S&P 500 and in the Russell 2000 Indexes. 

Bottom Line: While I think the current environment is top-heavy with potential risks for stock investors, even without a black swan event, the fact that the U.S. Federal Reserve is now forecasting a faster track for interest rate hikes this year (a March hike now looks likely to me) should be enough to contribute to a serious stock market correction over the very near term. 

S&P 500 Index with 3-Standard Deviation Bollinger Bands

Russell 2000 Index with 3-Standard Deviation Bollinger Bands

The Trump Rally In U.S. Stocks Is Over!

Since the intra-day low of 2,084.59 on November 3rd, 2016 the S&P 500 Index has rallied 8.39% to Friday's record closing high at 2,259.53. While U.S. stock futures are higher tonight (Sunday, December 11th), by tomorrow's NY close (Monday, December 12th) I believe the tide will have turned and a major stock market correction will be underway.

As can be seen on the daily, weekly, and monthly charts below, the S&P has now advanced to its 3-standard deviation upper Bollinger Band, where mean-reversion corrections are almost inevitable.

I see this so-called "Trump Rally" as a terminal advance that will ultimately be viewed as THE TOP in the current 93-month old bull market that began in March 2009.

All the usual variables that contribute to bear markets will soon be in force here as follows:

1. The Federal Reserve is raising interest rates and is now in tightening mode (at least for the short term - "Don't fight the Fed!").

2. The U.S. economy is probably already in recession, but official declines in GDP, as reported by the Commerce Department, won't probably be reported until the first quarter of 2017. Corporate earnings will deteriorate rapidly and P/E ratios will soon revert to more realistic values from current historical highs. Corporate buy-back programs will quickly disappear and central bank buying of stocks on a global basis will evaporate.

3. President-elect Trump and his potential Administration will raise domestic and international levels of uncertainty in the financial markets as his policies generate confusion and controversy at almost every level of Government.

4. The latest CIA report on Russian interference in U.S. elections has the potential to be a "Black Swan" of unprecedented proportions for investors as the validity and legitimacy of a Trump Presidency is called into question.

5. Crude Oil prices have more than doubled since their lows as posted in early 2016. This latest production agreement among OPEC and Non-OPEC countries, as reported today, may be a short term positive for energy-related companies, but higher energy prices are ultimately a huge negative for the global economies in general.

In the interest of full disclosure, I am short the S&P 500 Index using the double-short SDS ETF as my favored investment choice for this bearish action.

S&P 500 Index Daily Chart with 3-Standard Deviation Bollinger Bands

S&P 500 Index Weekly Chart with 3-Standard Deviation Bollinger Bands

S&P 500 Index Monthly Chart with 3-Standard Deviation Bollinger Bands