By Regina Roberts
As the bulls continue to dominate the market narrative, the emergence of divergences and other technical warnings sends a clear message – caution is crucial at this juncture.
In January 2020, we made a case for taking profits and reducing risk in our portfolios. Despite the market’s exuberance at the time, we felt that some prudence was in order. Just over a month after our warning, the markets experienced a sharp decline as the “pandemic” took hold. This episode is a reminder that even during buoyant times, the slightest trigger can ignite a correction.
“When you sit down with your portfolio management team, and the first comment made is ‘this is nuts,’ it’s probably time to think about your overall portfolio risk. On Friday, that was how the investment committee both started and ended – ‘this is nuts.’” – January 11th, 2020.
The S&P 500 index is now on the cusp of another psychological milestone of 5000, with numerous warning signs hinting at an elevated risk of a correction. Does this mean a correction is imminent? Certainly not. As the old adage goes, “Markets can remain irrational longer than you can remain solvent.” However, it is essential to remember that, as in 2020, it took more than a month before the cautionary signs materialized into reality.
Conversely, just last October, we discussed why a rally was probable. The backdrop then was almost the polar opposite of what we are witnessing today. There was a prevalent bearish investor sentiment coupled with negative technical indicator divergences, and analysts were slashing year-end price targets at a rapid pace.
What transpired next was the longest winning streak in 52 years that propelled the market to unprecedented all-time highs.
Historically, the last time we witnessed such a remarkable rally was between November 1971 and February 1972. Notably, the “Nifty Fifty” rally preceded the 1973-74 bear market. Similarly, today, a handful of stocks are propelling the markets upwards as interest rates soar along with inflation.
While there are considerable disparities between the current environment and that of the past, there are valid reasons to be wary.
The “New Nifty 50”
My colleague Albert Edwards at Societe Generale recently highlighted the surging capitalization of the technology market.
“I never thought we would get back to the point where the value of the US tech sector once again comprised an incredible one third of the US equity market. This just pips the previous all-time peak seen on 17 July 2000 at the height of the Nasdaq tech bubble.
What’s more, this high has been reached with only three of the ‘Magnificant-7’ internet stocks actually being in the tech sector (Apple, Microsoft, and Nvidia)! If you add in the market cap of Amazon, Meta, Alphabet (Google) and Tesla, then the IT and ‘internet’ stocks dominate like never before.”
Undoubtedly, there are significant disparities between today and the “Dot.com” era. Most notably, unlike then, technology companies currently generate substantial revenues and profits. However, a similar scenario unfolded with the “Nifty-50” in the early 70s. The enduring issue always revolves around the sustainability of these earnings and growth rates, along with the valuations paid for them. Any event that disrupts earnings growth will inevitably lead to downward revisions in valuation multiples.
While the economic landscape has yet to catch up with technology companies, the divergence in corporate profits between the Technology sector and the rest of the market seems unsustainable.
This inability to match the pace of expectations is already manifesting, and this disparity poses a significant risk to investors.
However, while the risk is apparent, the market’s “bullishness”
Nonetheless, notwithstanding valuations, these stocks could continue their upward trajectory in the short term (6-18 months) as speculative flows persist. Nevertheless, over the next few months, some divergences and indicators necessitate prudence. In our BullBearReport, we closely monitor investor sentiment every weekend. This is because when investor sentiment is exceedingly bullish or bearish, it usually signals an impending reversal. As emphasized by Sam Stovall, the investment strategist for Standard & Poor’s: “If everybody’s optimistic, who is left to buy? If everybody’s pessimistic, who’s left to sell?” Presently, the market sees overwhelmingly bullish sentiment. Bank of America, a prominent asset custodian, monitors risk positioning across equities. The current “risk love” ranks in the 83rd percentile, levels that have historically preceded short-term corrective actions. Furthermore, retail and professional investors are exuberant, as noted on Tuesday. “Another measure of bullish sentiment is comparing investor sentiment to the volatility index. Low levels of volatility exist when there is little concern about a market correction. Low volatility and bullish sentiment are often cozy roommates. The chart below compares the VIX/Sentiment ratio to the S&P Index. Once again, this measure suggests that markets are at risk of a short-term price correction.” Yet, while market sentiment is overwhelmingly bullish, the internal divergence of stocks voices caution. Andrei Sota recently illustrated that despite record highs, market breadth is waning. Historically, prior market peaks coincided with peaks in the percentage of stocks above their 20, 50, and 200-day moving averages. To underscore this point, consider the following Tweet from Jason Goepfert of Sentimentrader: “Man, The S&P 500 has nearly reached a 3-year high, yet all may not be as rosy as it appears at first glance. In a surprising statistic dating back to 1928, the current situation has only been witnessed once before, on August 8, 1929: fewer than 40% of its stocks are above their 10-day average, fewer than 60% above their 50-day, and fewer than 70% above their 200-day. This negative divergence should serve as a red flag to investors. The logical response to these warning signs would be to flee to the safety of cash until the storm passes. However, history tells us that such a move, while seemingly prudent, might not be the best course of action. “Well, if this is nuts, why not go to cash and wait out the correction and then buy back in,” Market veteran Albert Edwards offers a sobering perspective, likening the current situation to the IT bubble in 2000. Exiting too soon can cause irreparable harm to investment performance. Speculative bull markets like the current one can persist longer than expected. Investors are challenged to balance the need for returns with the fear of exiting prematurely or too late. While acknowledging the presence of a speculative frenzy, measures are being taken to cautiously reduce equity exposure and realign risk. Could this approach be flawed? Most certainly. However, a host of indicators are signaling caution, and treading carefully seems prudent. What’s the greater concern: missing out momentarily on short-term gains or enduring a lengthy journey back to breakeven, which is not equivalent to making profits? “Opportunities are made up far easier than lost capital.” – Todd Harrison Lance Roberts, Chief Portfolio Strategist/Economist for RIA Advisors, emphasizes the need for vigilance and urges investors to navigate these uncharted waters with care. Technical Divergences Add To The Risk
Investors Beware: Market Warning Signals Are Flashing
Questioning the Move to Cash
