Stock Markets Hyper-Risky 2

The US stock markets enjoyed an extraordinary surge in 2017, shattering all kinds of records. This was fueled by hopes for big tax cuts soon since Republicans regained control of the US government. But such relentless rallying has catapulted complacency, euphoria, and valuations to dangerous bull-slaying extremes. This has left today’s beloved and lofty stock markets hyper-risky, with serious selloffs looming large.

History proves that stock markets are forever cyclical, no trend lasts forever. Great bulls and bears alike eventually run their courses and give up their ghosts. Sooner or later every secular trend yields to extreme sentiment peaking, then the markets inevitably reverse. Popular greed late in bulls, and fear late in bears, ultimately hits unsustainable climaxes. All near-term buyers or sellers are sucked in, killing the trend.

This mighty stock bull born way back in March 2009 has proven exceptional in countless ways. As of mid-December, the flagship S&P 500 broad-market stock index (SPX) has powered 297.6% higher over 8.8 years! Investors take this for granted, but it’s far from normal. That makes this bull the third-largest and second-longest in US stock-market history. And the superior bull specimens vividly highlight market cyclicality.

The SPX’s biggest and longest bull on record soared 417% higher between October 1990 and March 2000. After it peaked in epic bubble-grade euphoria, the SPX soon yielded to a brutal 49% bear market over the next 2.6 years. The SPX wouldn’t decisively power above those bull-topping levels until 12.9 years later in early 2013, thanks to the Fed’s unprecedented QE3 campaign! The greatest bull ended in tears.

The second-largest bull was a 325% monster between July 1932 to March 1937. But that illuminated the inexorable cyclicality of stock markets too, as it arose from the ashes of a soul-crushing 89% bear in the aftermath of 1929’s infamous stock-market crash. Seeing today’s central-bank-inflated bull balloon to such monstrous proportions rivaling the greatest stock bulls on record highlights how extreme it has become.

All throughout stock-market history, this binary bull-bear cycle has persisted. Though some bulls grow bigger and last longer than others, all eventually give way to subsequent bears to rebalance sentiment and valuations. So stock investing late in any bull market, which is when investors complacently assume it will last indefinitely, is hyper-risky. Bear markets start at serious 20% SPX losses, and often approach 50%!

Popular psychology in peaking bull markets is well-studied and predictable. Investors universally believe “this time is different”, that some new factor leaves their bull impregnable and able to keep on powering higher indefinitely. This new-era mindset fuels extreme euphoria and complacency, with memories of big selloffs fading. Investors’ hubris swells, as they forget markets are cyclical and ridicule any who dare warn.

To any serious student of stock-market history, there’s little doubt today’s stock-market situation feels exactly like a major bull-market topping. All the necessary ingredients are in place, ranging from extreme greed-drenched sentiment to extreme bubble valuations literally. If this bull was merely normal, the risks of an imminent countertrend bear erupting to eradicate these late-bull excesses would absolutely be stellar.

But the downside risks in the wake of this exceptional bull are far greater than usual. That’s because much of this bull is artificial, essentially a Fed-conjured illusion. And that was even before the incredible 2017 taxphoria surge in the wake of Trump’s surprise victory! Back in early 2013 as the SPX was finally regaining its previous bull’s peak, the Fed unleashed its wildly-unprecedented open-ended QE3 campaign.

Understanding the Fed’s role in fomenting this anomalous stock bull is more important than ever. Not only is the Fed deep into its 12th rate-hike cycle (  ) of the past half-century or so, it has begun quantitative tightening for the first time ever. This QT is starting to unwind the trillions of dollars of QE that levitated the stock markets for years. While QT started small in Q4’17, it’s ramping to a $50b-per-month pace in Q4’18!

The Fed’s QE giveth, so the Fed’s QT taketh away. Literally trillions of dollars of capital evoked out of nothing by the Fed to monetize bonds directly and indirectly bid stock markets higher. The Fed’s deep intertwinement in this stock bull’s fortunes is easiest to understand with a chart. Here the SPX in blue is superimposed over its implied-volatility index, the famous VIX that acts as a proxy for popular greed and fear.

This anomalous stock bull was again birthed in March 2009 in the wake of the first true stock panic since 1907. After that epic maelstrom of fear fueled such an extreme plummet to climax a 57% bear market, a new bull was indeed overdue despite rampant bearishness and pessimism. The very trading day before the SPX bottomed, I wrote a hardcore contrarian essay explaining why a major new bull market was imminent.

Back in early 2009 stock-market valuations were so low after the panic that a new bull was fully justified fundamentally. And its first four years or so played out perfectly normally. Between early 2009 to late 2012, this bull market’s trajectory was typical. It rocketed higher initially out of deep bear lows, but those gains moderated as this bull matured. And its upside progress was punctuated by healthy major corrections.

Stock-market selloffs are generally defined in set ranges. Anything under 4% isn’t worth classifying, it is just normal market noise. Then from 4% to 10%, selloffs become pullbacks. Beyond that in the 10%-to-20% range are corrections. Selloffs greater than 20% are formally considered bear markets. In both 2010 and 2011 the SPX suffered major corrections in the upper teens, which are essential to rebalance sentiment.

As bull markets power higher, greed naturally grows among investors and speculators. They start to get very complacent and expect higher stocks indefinitely. Eventually this metastasizes into euphoria and even hubris. Major corrections, big and sharp mid-bull selloffs, rekindle fear to offset excessive greed and keep bulls healthy. Interestingly even in 2010 and 2011 the Fed played a key role in stock-market timing.

Those early bull years’ major corrections coincided exactly with the ends of the Fed’s first and second quantitative-easing campaigns. QE is an extreme monetary-policy measure central banks can use after they force interest rates, their normal tool, down to zero. The Fed’s zero-interest-rate policy went live in mid-December 2008 in response to that first stock panic in a century, and QE1 then QE2 soon followed.

Quantitative easing involves creating new money out of thin air to buy up bonds, effectively monetizing debt. While QE1 and QE2 certainly caused market distortions, both campaigns had predetermined sizes and durations. When traders knew a particular QE campaign was nearing its end, they started selling stocks which drove the major corrections. So the Fed decided to change tactics when it launched QE3.

As the SPX approached 1450 in late 2012, that normal stock-market bull was topping due to expensive valuations. After peaking in April, stock markets started rolling over heading into that year’s presidential election. Stock-market fortunes in the final several months leading into elections can greatly sway their outcomes. So in mid-September 2012 less than 8 weeks before the election, a very-political Fed hatched QE3.

QE3 was radically different from QE1 and QE2 in that it was totally open-ended. Unlike its predecessors, QE3 had no predetermined size or duration! So stock traders couldn’t anticipate when QE3 would end or how big it would get. Stock markets surged on QE3’s announcement and subsequent expansion a few months later. Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.

Whenever the stock markets started to sell off, Fed officials would rush to their soapboxes to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory. Traders realized that the Fed was effectively backstopping the stock markets! So greed flourished unchecked by corrections.

This stock bull went from normal between 2009 to 2012 to literally central-bank conjured from 2013 on! The Fed’s QE3-expansion promises so enthralled traders that the SPX went an astounding 3.6 years without a correction between late 2011 to mid-2015, one of the longest-such spans ever. With the Fed jawboning negating healthy sentiment-rebalancing corrections, sentiment grew ever more greedy and complacent.

QE3 was finally wound down in late 2014, leading to this Fed-goosed stock bull stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 to 2015 never would’ve happened! One of the most-damning charts of recent years shows the SPX perfectly tracking the growth in the Fed’s balance sheet as its monetized bonds accumulated there. This great stock bull is largely fake.

Without the Fed’s QE firehose blasting new money into the system, stock-market corrections resumed in mid-2015 and early 2016. After topping in May 2015 not much higher than QE3-ending levels, the SPX drifted sideways to lower for fully 13.7 months. That too should’ve proven this artificially-extended bull’s top, giving way to the overdue subsequent bear. But it was miraculously short-circuited by the Brexit vote.

Heading into late June 2016, Wall Street was forecasting a sharp global stock-market selloff if British people actually voted to leave the EU. What was seen as a low-probability outcome promised to unleash all kinds of uncertainty and chaos. And indeed when that Brexit vote surprised and passed, the SPX plunged for a couple trading days. Then meddling central banks stepped in assuring they were ready to intervene.

So this tired old bull again started surging to new record highs in July and August 2016, although they weren’t much better than May 2015’s. After that euphoric surge on hopes for post-Brexit-vote central-bank easings, the SPX started to roll over again heading into the US presidential election. Wall Street warned just like Brexit that a Trump win would ignite a major stock-market selloff, and again proved dead wrong.

The shocking post-election stock surge has been called Trumphoria or taxphoria. Capital flooded into stocks for a variety of reasons. In addition to hopes for far-superior government policies boosting corporate profits, funds rushed to buy to chase good year-end gains to report to their investors. And the resulting stock-market record highs, and fevered anticipation for big tax cuts, started seducing investors back.

This exuberant psychology greatly intensified in 2017, with the SPX periodically surging to series of new record highs on political news fanning investors’ optimism. Since Trump won the election, nearly all of the SPX’s significant daily rallies ignited on news implying big tax cuts were indeed coming soon as widely hoped. The wealth effect from that stock elation unleashed big spending, which really boosted corporate profits.

But this Fed-goosed stock bull was already very long in the tooth, and stock valuations were already near formal bubble territory, even before Trump was elected. The resulting Trumphoria surge on hopes for big tax cuts soon really exacerbated serious pre-election risks. That included extending the span since the end of the last SPX correction to 1.9 years. Normal healthy bull markets see correction-grade selloffs annually.

Between the SPX’s original top in May 2015 soon after QE3 ended and Election Day 2016, at best stock markets simply ground sideways. At worst they were rolling over into what should’ve grown into a major new bear. Trumphoria short-circuited all that, sending stocks sharply higher and delaying the inevitable cyclical reckoning. By mid-December 2017 the SPX had rocketed a crazy 25.7% higher since Election Day alone!

An ominous side effect of that anomalous late-bull surge was extremely-low volatility, with all kinds of low-volatility records set. The VIX S&P 500 implied-volatility index on this chart reflects that, slumping to multi-decade lows throughout 2017! Low volatility reflects low fear and high complacency, the exact herd sentiment ubiquitous at major bull-market toppings. Just like stock markets, volatility is forever cyclical too.

Volatility often skyrockets off exceptional lows, as the great sentiment pendulum must swing back to fear after peaking deep in the greed side of its arc. And the only thing that generates fear late in stock bulls is sharp selloffs. No matter how bad news is, euphoric investors happily ignore it if it doesn’t drive stocks lower. But eventually some catalyst always arrives, usually unforeseen, that finally stakes the geriatric bull.

When the last stock bulls peaked in March 2000 and October 2007, there was no specific news that killed them. Lofty euphoric stock markets simply started gradually rolling over, mostly through relatively-minor down days which generated little fear. These modest grinds lower kept most investors unaware of the waking bears, boiling them slowly like the proverbial frog in the pot. But even little losses eventually add up.

Since nearly all the amazing stock-market gains between late 2012 to mid-2015 were directly fueled by the Fed’s QE3 money printing, fears of the coming quantitative tightening may prove the bull-slaying catalyst. The Fed conjured money out of thin air to buy bonds in QE, and it will destroy that very money by effectively selling bonds in QT. QT’s capital outflows should prove as bearish for stocks as QE’s inflows were bullish!

The FOMC actually started discussing QT at its early-May meeting, and formally announced it at its late-September meeting. QT actually got underway in Q4’17 at a modest $10b-per-month pace. But it’s on autopilot to grow by $10b per month each quarter until it reaches terminal speed at a $50b-per-month pace in Q4’18. That will make for $600b per year of QE-injected capital removed from markets and destroyed.

QT is utterly unprecedented in history, and its acceleration in 2018 has profoundly-bearish implications for these QE-inflated record stock markets. As QT started late in 2017 at low levels, it only totaled $30b this year. But in 2018 alone that will explode 14x higher to a total of $420b of QT! Prudent investors will sell in anticipation of QT hitting full steam, as unwinding the Fed’s huge QE-bloated balance sheet is a grave threat.

Back in the first 8 months of 2008 before that stock panic, the Fed’s balance sheet averaged $849b. By February 2015, it had ballooned to a freakish $4474b. That’s up a staggering 427% or $3625b over 6.5 years of QE! QE levitated the stock markets in two primary ways. That Fed bond buying bullied yields to artificial lows, forcing bond investors starving for yields to buy far-riskier stocks that were paying dividends.

More importantly, those unnatural contrived extremely-low yields courtesy of QE fueled a boom in stock buybacks by corporations unlike anything ever witnessed. American companies took advantage of the crazy-low interest rates to literally borrow trillions of dollars to buy back their own stocks! Between QE3’s launch and Trump’s victory, corporate stock buybacks were the dominant source of stock-market capital inflows.

QT along with the Fed’s current rate-hike cycle will allow bond yields to rise again, eventually greatly retarding corporations’ desire and ability to borrow vast sums of money to use to manipulate their own stock prices higher. In late December, the Fed’s balance sheet was still way up at $4408b. These QE-inflated stock markets have never experienced QT, and it ain’t gonna be pretty no matter how slowly QT is implemented.

While this easy Fed is far too cowardly to fully reverse $3.6t worth of QE since late 2008, even a trillion or two of QT over the coming years is going to wreak havoc on these QE-levitated stock markets! That’s a serious problem for today’s extreme Fed-goosed bull with a rotten fundamental foundation. Underlying corporate earnings never supported such extreme record stock prices, and the coming reckoning is unavoidable.

Regardless of the Fed’s balance sheet, quantitative tightening, or valuations, the near-record-low VIX slumping into the 9s since back in May shows these stock markets are ripe for a major selloff anyway. At absolute minimum, it needs to be a serious correction approaching 20%. But with this stock bull so big, so old, and so fake thanks to the Fed, that selloff is almost certain to snowball into the long-overdue next bear.

And investors aren’t taking the threat of a new bear seriously. Crossing the bear threshold just requires a 20% retreat. Even such a baby bear would erase all SPX gains since mid-2016. A normal bear market at this stage in the Long Valuation Waves is actually 50%, cutting stock prices in half! That would wipe out the great majority of this entire mighty stock bull, dragging the SPX all the way back down to mid-2011 levels.

Even more ominously, bear markets naturally following bulls tend to be proportional. That makes sense since bears’ job is to rebalance sentiment and work off overvalued conditions. So there’s a high chance the coming bear after such an anomalous Fed-goosed bull won’t stop at 50%! The downside risks from here are incredibly dire after such a huge bull driven by extreme central-bank easing instead of corporate profits.

And that finally brings us to valuations, this old stock bull’s core problem. This final chart looks at the SPX superimposed over a couple key valuation metrics. Both are derived from averaging the trailing-twelve-month price-to-earnings ratios of all 500 elite SPX companies. The light-blue line is their simple average, while the dark-blue one is weighted by market capitalization. Today’s valuations ought to terrify investors.

Unfortunately today corporate earnings are intentionally obscured by Wall Street to mask the dangerous overvaluation that is rampant. Analysts make up blatant fictions including forward earnings, which are literally guesses about what companies will earn in the coming year! These almost always prove wildly optimistic. Analysts also look at adjusted earnings, another Pollyannaish farce where companies ignore expenses.

Wall Street also plays a deceptive estimate game to make quarterly-earnings results look way better than they really are. Instead of comparing actual hard quarterly profits with the same quarter a year earlier, they intentionally lowball estimates so companies beat regardless of their actual earnings trends. Investors are being bamboozled, with the only honest way of measuring corporate profits buried and forgotten.

That is based on generally-accepted accounting principles which are required when companies actually report to regulators. The only righteous way to measure price-to-earnings ratios is using the last four quarters of GAAP profits, or trailing twelve months. Those numbers are hard, established in the real world based on real sales and real expenses. They are not mere estimates like totally-bogus forward earnings.

Every month at Zeal we look at the TTM P/Es of all 500 SPX companies. At the end of November, the simple average of all SPX companies actually earning profits so they can have P/Es was an astounding 30.5x! That’s literally in bubble territory, just as Trump had warned about during his campaign. 14x earnings is the historical fair value over a century and a quarter, and double that at 28x is where bubble levels start.

If you study the history of the stock markets, stock prices never do well for long starting from bubble valuations. Such extreme stock prices relative to underlying corporate earnings streams actually herald the births of major new bear markets. Again these usually cut stock prices in half. So buying stocks here, late in a huge old bull market artificially levitated by the Fed, is the height of folly. Massive losses are inevitable.

Remember stock markets perpetually meander through alternating bull-bear cycles. Back in late 2012 before the Fed stepped in to try and brazenly short-circuit these valuation-driven cycles, valuations were actually in a secular-bear downtrend. After secular bulls drive valuations to bubble extremes, with greed forcing stock prices far beyond underlying corporate earnings, secular bears emerge to reverse those excesses.

During secular bears, stock prices grind sideways on balance for long enough for earnings to catch up with lofty stock prices. Before QE3 temporarily broke stock-market cycles, that process had been happening as normal between 2000 to 2012. Secular bears don’t end until valuations get to half fair value, 7x earnings. So instead of being into bubble levels, valuations would normally be between 7x to 10x today.

That’s the massive downside risk stocks face due to their Fed-conjured bubble valuations! While the red line above shows the actual SPX, the white line shows where it would be trading at 14x fair value. Even that is way down around 1235 today, less than half current levels! But mean reversions from extremes nearly always overshoot in the opposite direction, so the potential SPX bear-market bottom is much lower.

Sadly Wall Street will never bother telling investors that valuations matter. Stock-market history proves beyond all doubt that buying stocks high in valuation terms nearly always leads to considerable-to-huge losses. All the financial industry cares about is keeping people fully invested no matter what, since that maximizes their fees derived from percentages of assets under management. Talk about a conflict of interest!

The more expensive stocks are in valuation terms when they are purchased, the worse the subsequent returns will be. And no matter how awesome Trump’s policies may ultimately prove, they aren’t going to rescue corporate profits anytime soon. Republicans’ corporate-tax cuts have long been way more than fully priced in to stock prices. Wall Street analysts love to claim 2017’s extraordinary rally was earnings-driven.

But valuations prove otherwise. By late November the SPX had soared 24.2% since Trump won the US presidency. But during nearly that same span the SPX’s simple-average TTM P/E surged 15.9%. That implies only about a third of the entire Trumphoria rally was driven by higher corporate profits! And even that is suspect, since the wealth effect from this year’s record stock markets fueled exceptionally-high spending.

The stock markets’ lofty valuations before Trumphoria and the bubble valuations since are a very serious problem that can only be resolved by an overdue major bear market! Only that will drag stock prices low enough for existing and future corporate earnings to support reasonable valuations again. Investors sure don’t believe a new bear market is possible, but they never do when bull markets are topping in extreme euphoria.

It’s not just the Fed’s QT that’s coming in 2018 and 2019, but the European Central Bank is also slashing its own QE campaign. That ran at a blistering €60b-per-month pace in 2017, totaling €720b. But it will be cut in half to just €30b a month starting in January. The combination of Fed QT and ECB QE tapering is going to strangle this stock bull! A QE-conjured stock bull can’t persist when QE is reversed and slashed.

Together these leading global central banks so critical to stock-market fortunes are effectively tightening massively in 2018 and 2019 compared to 2017. Next year alone will see the equivalent of $950b more Fed QT and less ECB QE than this year. Can bubble-valued stocks survive nearly a trillion dollars less central-bank liquidity in 2018? And two years from now that will swell to another $1450b less than this year!

Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming central-bank-tightening-triggered valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power grows. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half price!

Put options on the leading SPY S&P 500 ETF can also be used to hedge downside risks. They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.

Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early that year. If the stock markets indeed roll over into a new bear in 2018, gold’s coming gains should be much greater. And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains. Gold stocks rocketed 182% higher in 2016’s first half!

Absolutely essential in bear markets is cultivating excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will, so we can later sell high when few others can. While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.

We’ve long published acclaimed weekly and monthly newsletters for speculators and investors. They draw on my vast experience, knowledge, wisdom, and ongoing research to explain what’s going on in the markets, why, and how to trade them with specific stocks. As of the end of Q3, all 967 stock trades recommended in real-time to our newsletter subscribers since 2001 averaged stellar annualized realized gains of +19.9%! For only $12 per issue, you can learn to think, trade, and thrive like contrarians. Subscribe today!

The bottom line is today’s euphoric record stock markets are hyper-risky. They are trading up at bubble valuations thanks to 2017’s stunning post-election rally. Such lofty stock prices are risky any time, but exceedingly dangerous late in an enormous bull market artificially extended by the Fed. A major new bear market is long overdue that will at least cut stock prices in half. Don’t be fooled by the extreme complacency!

Prudent investors have to overcome this groupthink herd euphoria and protect themselves from what’s coming. That means lightening up on overvalued stocks, building cash, and buying gold. Central banks have a long history of trying and failing to eliminate stock-market cycles. The longer they are artificially suppressed, the worse the inevitable reckoning as these inexorable market cycles resume with a vengeance.

Adam Hamilton, CPA

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