Tops never form cleanly.
I’ve made the mistake of attempting to call a top on the “dot” in the past. The reality is that anyone who attempts to do so is exercising their ego more than their judgment.
Market tops occur when investor psychology changes. But it’s not a clean shift. Investors, like any category of people, are comprised of numerous groups or sub-sects: some get it sooner than others.
In this sense there are certain tell tale signs that a top is forming. This doesn’t mean a top is “in” nor does it imply a specific timeline for a top to form (say a week vs. a few weeks).
However, there are clear signals that appear around tops. And I want to alert you that multiple ones are flashing right now.
First and foremost, investor complacency as measured by the VIX (a measure of how much investors are willing to pay for portfolio hedging and protection) is now at or near record lows:
Indeed, if we were to analyze the VIX from a technical analysis perspective, we have the mother of all falling wedge patterns forming here. Given that we’re talking about the VIX here, the likelihood of a major breakout to the downside is minimal (we can’t go negative).
In this light, if and when the VIX breaks out to the upside from this formation, we should see a move to at least 40 or 45.
To put this number in perspective, this is where the VIX traded during the 2010 Flash Crash and the 2011 debt-ceiling crisis when the US lost its AAA credit rating.
Put simply, the formation in the VIX today is forecasting that we will see a move in the markets on par with the 2010 market top/ Flash Crash or the 2011 debt ceiling crisis. The S&P 500 fell 16% from peak to trough during both of these instances.
We get additional confirmation that the market is likely forming a top from the “smart money.”
Over the last 12 months, institutional investors have been net sellers of stocks for most of the time. This trend became much more pronounced in July with institutions selling an average of $1 billion in stocks during that period (see Figure 4 on the next page).
In particular I want to note that institutional investors are dumping stocks at a pace last seen in the first half of 2008. We all know what came next.
Among the financial institutions that are dumping stocks include Apollo Group, Blackstone Group, and Fortress Investment Group. These groups are not only selling themselves, but have been urging their high net worth clients to sell stocks as well.
In addition to this, those at the top of the corporate food chain are uneasy with the prospects for economic growth. According to Markit’s semi-annual Global Business Outlook Survey of 11,000 CEOs found Chief Executives to be the most negative since the depths of the Great Recession in early 2009.
Thus, we see the “smart money” exiting the markets. We also see fewer and fewer companies participating in the market rally. Those who run these companies are more pessimistic than at any point in the last five years dating back to the nadir of the 2009 collapse. And finally we have investors as a whole displaying the most complacency about the market in history.
Finally, there are major valuation concerns for the markets today. When pricing stocks, I like to use the CAPE, not the P/E ratio. If you’re unfamiliar with CAPE it is the cyclically adjusted price-to-earnings ratio.
In simple terms CAPE measures the price of stocks against the average of ten years’ worth of earnings, adjusted for inflation.
The reason you use the average earnings over 10 years is due to the business cycle. Typically the US experiences a boom and bust once every ten years or so.
By using the average earnings over a ten-year period, you smooth out your earnings data to account for both booms and busts. As a result you get a much clearer measure of a business’s profits which is the best means of valuing that business’s worth.
Today the S&P 500 has a CAPE of over 25. This means the market as a whole is trading at 25 times its average earnings of the last ten years.
Put another way, if you bought the entire stock market today, it would take you roughly 22 years to make your money back.
That is hardly what I’d call cheap.
However, generally speaking, stocks are showing all of the hallmark signs of topping out. The market is overpriced, overbought, the smart money is selling, CEOs are bearish, market breadth is shrinking and earnings growth looks poor.
When this correction finally comes… it could be BIG one.
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Phoenix Capital Research