These record US stock-market levels are very dangerous, riddled with extreme levels of euphoria and complacency. Largely thanks to the Fed, traders are convinced stocks can rally indefinitely. But stock prices are very expensive relative to underlying corporate earnings, with valuations back up near bubble levels. These are classic topping signs, with profits growth stalling and the Fed out of easy dovish ammunition.
Stock markets are forever cyclical, meandering in an endless series of bulls and bears. The latter phase of these cycles is inevitable, like winter following summer. Traders grow too excited in bull markets, and bid up stock prices far higher than their fundamentals support. Subsequent bear markets are necessary to eradicate unsustainable valuation excesses, forcing stock prices sideways to lower until profits catch up.
This latest bull market grew into a raging monster largely fueled by extreme Fed easing. At its latest all-time record peak hit just this week, the flagship US S&P 500 broad-market stock index (SPX) has soared 335.4% higher over 10.1 years! That makes for the second-biggest and first-longest bull in US history, only possible because it gorged on $3625b of quantitative-easing money printing by the Fed over 6.7 years.
That epic 5.3x mushrooming of the Fed’s balance sheet peaked in February 2015, when the SPX was just clawing over 2100. It soon coasted to a 2130.8 topping in May 2015, before trading sideways to lower for 13.7 months without Fed QE. Modest new highs weren’t seen until July 2016, after the UK’s Brexit-vote surprise kindled hopes for more central-bank easing. Another surprise event drove the final third of this bull.
The November 2016 elections were a Republican sweep, with Trump winning the presidency while his party controlled both chambers of Congress. So the SPX started surging to new record highs, initially on hopes for big tax cuts soon and later on record corporate tax cuts becoming law. That ultimately propelled the SPX to 2872.9 in late January 2018 and 2930.8 in late September 2018, lofty new all-time record highs.
But paraphrasing an ancient Biblical passage from Job, the Fed gave then the Fed took away. Right after the SPX peaked, the Fed ramped its year-old quantitative-tightening campaign to full speed in Q4’18. QT was supposed to unwind a large fraction of that $3625b of QE-conjured money, shrinking the Fed’s crazy-bloated balance sheet. $50b per month of QT monetary destruction had to be this QE-fueled bull’s death knell!
Indeed the stock markets crumbled under that Fed-tightening onslaught, plunging 19.8% over the next 3.1 months into late December 2018. That severe correction was right on the verge of crossing the -20% threshold into new-bear territory. Over a third of those serious losses happened in just 4 trading days after the Fed chairman declared full-speed QT was “on automatic pilot”. By that time the SPX was very oversold.
Stock-market extremes never last long, with big and sharp mean-reversion bounces following major selloffs. The SPX reversed hard and soared into early 2019, already 12.3% higher by late January. Then the Fed’s first policy decision after that stock-crushing QT-autopilot one saw this central bank completely cave to the stock markets. It removed references to further rate hikes and declared it was ready to adjust QT.
That dovishness unleashed more waves of momentum buying. By the eve of the Fed’s next meeting in mid-March, the SPX had rocketed 20.5% above its severe-correction near-bear low. But that wasn’t good enough for the Fed, which slashed its future-rate-hike outlook while declaring it would essentially stop QT by September 2019. That is very premature, implying less than 23% of the Fed’s total QE will be unwound!
That goosed the stock markets again, helping push the SPX to an enormous 25.3% rebound-rally gain by this week. At 2945.8, it had edged 0.5% above late September’s then-record peak. With stock markets more than regaining their big losses, euphoria and complacency exploded again. These herd emotions have proven dangerous in market history, marking major toppings including terminal bulls rolling over to bears.
Euphoria is simply “a strong feeling of happiness, confidence, or well-being”. It is always accompanied by complacency, which is “a feeling of contentment or self-satisfaction, especially when coupled with an unawareness of danger or trouble”. This perfectly describes the stock markets’ sentiment-scape in recent months. Speculators and investors just love these lofty stock prices, with virtually no fear of material selloffs.
While euphoria and complacency are ethereal and unmeasurable, they can be inferred. The classic VIX fear gauge is the most-popular way. It quantifies the implied volatility options traders expect in the SPX over the next month, as expressed through their collective trades. While a high VIX reveals fear, a low one shows the direct opposite which is complacency. In mid-April the VIX revisited ominous bull-slaying levels.
This chart superimposes the SPX over its VIX sentiment indicator over the past several years or so. This monster Fed-QE-fueled stock bull sure looks to be carving a massive triple top in its terminal phase. At best in late April, the SPX had merely clawed back 2.5% over its initial peak of late January 2018. That’s terrible progress across 15.1 months where the biggest corporate tax cuts in US history greatly boosted profits.
While the first two-thirds of this monster bull were directly driven by the Fed’s extreme QE, the final third was corporate-tax-cut driven. Starting with that November 2016 Republican sweep, there was enormous anticipation of what eventually became the Tax Cuts and Jobs Act. Signed into law in December 2017, it went into effect as 2018 dawned. Its centerpiece was slashing the US corporate tax rate from 35% to 21%.
The SPX surged 19.4% in 2017 in the thrall of taxphoria hopes, driving 62 new record-high closes out of 251 trading days! The first 18 trading days of 2018 saw another 14 more, catapulting both euphoria and complacency off the charts. The VIX slumped into the 9s early that peaking month, proving that fear was nonexistent. Virtually no one expected a selloff when the SPX peaked at 2872.9, when the VIX closed at 11.1.
But just when traders were convinced stock markets could rally indefinitely with no material selloffs, the SPX suddenly nosed over into its first correction in 2.0 years. While sharp yet shallow and short at a 10.2% loss in just 0.4 months, it was a warning shot. Even with elite SPX companies’ corporate profits expected to soar 20%+ that year due to those big tax cuts, stock markets were already too high to rally much.
After that minor flash correction, the SPX started marching higher again throughout 2018. It wasn’t able to eclipse January’s maiden peak until late August, and ultimately crested merely 2.0% above it in late September. Such meager gains again suggested the corporate tax cuts were nearly fully priced in during 2017, leaving little room for additional gains. The day the SPX peaked at 2930.8, the VIX closed at 11.8.
Once again traders’ euphoria and complacency were extreme. The pressure on contrarians to capitulate was immense. But given the extreme stock-market technicals, sentiment, and valuations, I stuck to my guns warning how dangerous the stock markets were. Just a week after that all-time record high in the SPX, I published an essay warning “Fed QT is Bull’s Death Knell” one trading day before QT hit terminal velocity.
Indeed the stock markets fell hard, plunging 19.8% over 3.1 months into late December! That correction was much larger and more menacing than early 2018’s, on the edge of formal bear-market territory. And it happened despite SPX companies’ earnings actually blasting 20.5% higher year-over-year in 2018. Two corrections, including a serious one, in one of the best corporate-profits years on record should give pause.
The stock markets were due for a sharp mean-reversion rebound higher after such a steep drop. But the Fed waxing hyper-dovish and killing both its rate-hike cycle and QT really artificially extended it. Just over half the total rebound rally came after the Fed utterly surrendered to stock traders starting in late January. Many larger SPX-rally days clustered around dovish Fed announcements, they really amplified this rally.
It looked and felt exactly like a bear-market rally, the biggest and fastest ever witnessed in stock markets. The SPX soared in a symmetrical V-bounce out of late December’s deep lows. Those gains were front-loaded, fast initially but fading in recent months despite the Fed’s super-dovish jawboning. That severe near-bear correction that spawned this rally also fit the definition of a waterfall decline, an ominous omen.
They are 15%+ SPX selloffs without any interrupting countertrend rallies exceeding 5%. Since 1946 this had happened only 19 previous times. After every single past selloff, 100% of the time, the SPX retested its waterfall-decline lows! All 19 happened in bear markets. After these retests, fully 15 of the 19 were followed by new lower lows as those bears deepened. Only 4 of the 19 waterfall retests climaxed their bears.
So market history is crystal-clear in warning that the wild stock-market action of the past 7.3 months is exceedingly dangerous technically. Yet euphoria and complacency still exploded again in March and April as the SPX kept stretching skywards. By mid-April as the SPX clawed back up to 2907.4, the VIX fell back under 12.0 on close. Those were the lowest levels of fear seen since October 3rd, a bearish portent.
While that was a couple weeks after the SPX’s late-September then-record peak, this leading stock index was still just 0.2% lower. The selling that would grow into the severe near-bear correction began the very next day, and snowballed from there. Right when traders again delude themselves into believing stock markets can rally indefinitely, the hard reality of market cycles slams them like a sledgehammer to the skull.
Extreme levels of euphoria and complacency are always very dangerous, presaging major stock-market selloffs. Low VIX levels following record or near-record stock-market highs should not be trifled with, but considered a dire warning of serious downside risks. Very-high technicals breed very-lopsided sentiment, blinding traders to markets’ perpetual cyclicality. Today’s risks are compounded by near-bubble valuations.
For a century-and-a-quarter or so before the Fed’s insane QE experiment starting in late 2008, the US stock markets had averaged trailing-twelve-month price-to-earnings ratios around 14x earnings. That is considered fair-value, which makes sense. The reciprocal of 14x is 7.1%, which is a fair rate for both investors to earn to let companies use their saved capital and for companies to pay to use those same funds.
But valuations oscillate well above and below fair value in great waves that correspond with bull and bear markets. In bulls stocks are enthusiastically bid to high valuations not justified by their underlying profits. Valuation extremes start at twice fair value, 28x trailing earnings which is formally bubble territory. That necessitates bears to maul stock prices long enough for earnings to catch up, but stocks usually overshoot.
While major bull markets end above 28x, major bear markets often end between 7x to 10x. That’s the time investors should throw all their capital at the stock markets, when stocks are dirt-cheap and deeply out of favor. But instead they foolishly buy high near bull-market tops, which often leads to selling low later at catastrophic losses. The SPX valuations during this 15-month triple-top span have been scary-high.
This next chart shows the actual SPX in red, superimposed over the average trailing-twelve-month price-to-earnings ratios of its 500 elite companies. Their simple average at the end of every month is shown in light blue, and is what I’m using in this essay. The dark-blue line instead weights SPX-component P/Es by their companies’ market capitalizations. The white line shows where the SPX would be at 14x fair-value.
Remember the final third of this monster bull erupted on taxphoria after Trump won the presidency. But following trillions of dollars of QE before that, the SPX wasn’t cheap heading into November 2016. These elite stocks averaged TTM P/Es of 26.3x, just shy of 28x bubble territory. Interestingly that was about the same valuation as the 25.9x when QE ended in February 2015. Stocks had long been very expensive.
SPX corporate earnings did rise nicely in 2017, up about 16%. Republicans streamlining regulations was a factor, but more important was the widespread optimism from stock markets surging to endless new record highs. But the problem was stocks were already so overvalued that higher profits barely made a dent. At best that year the fair-value SPX at 14x hit 1296.0, a staggering 52% below the SPX’s 2017 high!
The SPX first crossed that 28x bubble threshold in late November 2016 after stocks surged higher on that Republican sweep. Valuations hung around 28x until July 2017 when they started climbing even higher. By late January 2018 just after the SPX’s initial peak, its elite companies were averaging TTM P/Es way up at 31.8x! While bubble valuations can persist while euphoria lasts, they are very dangerous for stocks.
SPX corporate-earnings growth in 2018 was amazing, exceeding 20% year-over-year thanks to those record corporate tax cuts. The four quarters of 2018 were the only ones comparing post-tax-cut and pre-tax-cut profits, an enormous one-off discontinuity. Yet damningly the valuations still didn’t retreat, in late September just after the SPX’s record peak its components were still averaging extreme 31.4x TTM P/Es.
That severe near-bear correction largely in Q4 last year certainly helped, dragging valuations back down out of bubble territory. But even at the end of December just after the lows, the SPX was still sporting a 26.1x valuation. That was near bubble territory, right around the levels just before Trump was elected. No bear market would end its predations and start hibernating while valuations remained so darned high!
In recent months many Wall Street apologists have claimed that severe correction was effectively a very-short-lived bear market since it was so close to 20% on a closing basis. They argue that means a new bull is underway that can run for years more. But bears don’t give up their ghosts after a single selloff with price-to-earnings ratios still near bubble levels. Bears ravage until valuations are mauled back under 14x.
Interestingly valuations haven’t soared back up with the massive rebound rally so far this year. By the end of April, the SPX components’ average P/E had only returned to 27.5x. That’s not greatly above the late-December levels. This was due to blowout Q4’18 earnings from SPX companies, the last quarter with profits compared across the Tax Cuts and Jobs Act. Q4’17 also rolled off, which the TCJA heavily distorted.
But 27.5x is still just under bubble territory, dangerously-expensive levels for stocks achieving record highs again. If the inevitable bear following the past decade’s enormous Fed-inflated monster bull just pushed stocks back down to 14x fair value, the SPX would have to plunge way back near 1400. That’s a heck of a long ways down from here, a 52% drop. Cutting stocks in half is right in line with bear-market precedent.
The SPX’s last bear market ran from October 2007 to March 2009, and pummeled this leading American stock index a gut-wrenching 56.8% lower in 1.4 years. That bear-market bottom birthed this current bull, when the SPX traded down to 12.6x earnings. Before that the SPX suffered another bear from March 2000 to October 2002, a 49.1% drop over 2.6 years. So 50%ish SPX losses are par for the course in bears!
Several factors could make this long-overdue next bear even worse. In 2016, 2017, and 2018, the elite SPX companies’ profits grew 9.3%, 16.2%, and 20.5% YoY. This year even Wall Street is forecasting earnings to be flat at best. There’s a real possibility they will even contract in 2019, the first year comparing post-tax-cut quarters. Stalling or shrinking corporate profits make near-bubble valuations even more extreme.
Lower profits actually push valuations even higher, increasing the valuation pressure for a major bear market. And with average month-end SPX TTM P/Es running 30.5x in 2018 at 20% profits growth, there’s no way similar high valuations will fly this year with zero profits growth. The more quarterly earnings fail to climb, the more worried traders will get over high stock prices and the more likely they will start selling.
And after the second-largest and first-longest bull market in US stock-market history, mostly driven by extreme Fed easing no less, the subsequent bear should be proportionally massive. There’s a fairly-high chance this bear won’t stop brutalizing stocks until the average SPX P/E falls near half fair-value around 7x earnings. That’s where the biggest bears in the past have ended, valuations overshot way under 14x.
Finally the Fed is going to have a hard time riding to the rescue again since it has expended all its easy dovish ammunition. It really only has three options left for another dovish surprise, and the latter two are very serious decisions. Top Fed officials’ outlook for rates in their collective dot-plot forecast can still be lowered to show cuts coming. But since these guys downplay the dot plot, that won’t mollify traders for long.
That leaves actually cutting rates or birthing QE4, which are huge course changes that the Fed can’t take lightly or revoke without panicking stock markets! With the Fed just about out of dovish rabbits to pull out of its hat, it doesn’t have many options to slow the selling when stock markets inevitably turn south again. Cutting rates or restarting QE may even exacerbate any selloff, worrying traders about what so scared the Fed.
The overdue bear market is still coming, make no mistake. Extreme technicals, sentiment, and valuations assure it. Investors really need to lighten up on their stock-heavy portfolios, and protect themselves with cash and gold. Holding cash through a 50% bear market allows investors to buy back their stocks at half-price, doubling their holdings. But unlike cash gold actually appreciates in value during bears, growing weath.
Gold investment demand surges as stock markets weaken, as we got a taste of in December. While the SPX plunged 9.2%, gold rallied 4.9% as investors flocked back. The gold miners’ stocks which leverage gold’s gains fared even better, with their leading index surging 10.7% higher. The last time a major SPX selloff awakened gold in the first half of 2016, it soared 30% higher fueling a massive 182% gold-stock upleg!
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The bottom line is these stock markets are very dangerous. A monster bull has been topping over the past year-and-quarter, leading to extreme technicals, sentiment, and valuations. Traders’ euphoria and complacency have been running at bull-slaying levels, while valuations remain way up near perilous bubble territory. All this is happening as corporate profits flatline after surging dramatically on the corporate tax cuts.
Like after every past waterfall decline, the stock markets are due to roll over and retest their deep late-December lows. Odds are they will fail, confirming a major new bear market. And the Fed doesn’t have much dovish ammunition left to retard the heavy selling. Gold investment demand will surge as stocks finally face their reckoning after this artificially-amplified bull. That will push gold and its miners’ stocks far higher.
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