The stock market has topped in multiple indices over a period of months. The Russell 2000 Index (small and mid-cap stocks) topped on March 4, the NYSE Composite Index (a very broad index) had its closing high on July 3 (and intraday high on September 4), the Dow Jones Utility Average hit its peak on November 5, Dow Jones Transportation Average on November 25, S&P Mid-Cap 400 Index on November 26, and both the NASDAQ and NASDAQ 100 peaked on November 28.
The general public sees the news reports that the Dow Jones Industrial Average (DJIA) and S&P 500 both hit all-time peaks on Friday, December 5 and thinks all is well, however, behind the headlines, there is another story to be told. At the peak, even though the DJIA was up over 8% for the year, nine of the 30 stocks in the index were down for the year. The S&P 500 was up over 12% for the year, yet one-third of the stocks in the index were down for the year and in the Russell 2000 over one-half of the stocks were down for the year, again, while the “stock market” was making new highs.
How is this possible? It is because the DJIA and S&P 500 are weighted by market cap. If some large companies do well, they can make the overall market performance look better than it is. One-third of the S&P 500’s gains have come from only 10 stocks!
It is also worth noting the composition of the S&P 500 changes over time. The number of energy stocks in the index has dropped 30% since 2008, now consisting of only 9.3% of the index. With the recent carnage in energy stocks due to the decline in the price of oil, using the 2008 composition, the index would be much lower already.
The market is dangerously overvalued, dollar strength is hurting earnings, bullish sentiment is at an extreme, there is record high margin debt, extreme complacency, and finally chart patterns appear to have confirmed a top for the large cap indices as well. If December 5 was not the final top, we are very close in both time and price for all indices to have their final tops.
By many measures, such as dividend yield or price to book value, the stock market is more overvalued now than it was in 1929! The stock market looks even more overvalued if you dig a little deeper. The Shiller Price/Earnings (P/E) ratio, developed by Nobel Prize-winning economist Robert Shiller, adjusts earnings for inflation and average corporate earnings over the prior 10 years. The current Shiller P/E ratio is 26.5, dangerously high compared to the historical average of 16. The stock market today in the U.S. is priced for utter perfection in a zero interest rate environment; any misstep at all could be the start of a major decline.
Dollar strength is causing companies with international sales to have reduced earnings. Proctor & Gamble called the dollar’s strength a “significant negative.”
There are numerous sentiment indicators which are near multi-decade extremes, for example, bearish investment advisors in Investment Intelligence Advisor’s Survey are near a 27 year low in bearishness.
Business school finance classes teach the efficient market hypothesis (EMH). It is an investment theory that states it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors, who are assumed to always be rational, to either purchase undervalued stocks or sell stocks for inflated prices.
What follows from this belief is that all those rational people making all those rational decisions always lead to rational stock market prices, and academics will point to a boatload of research data to prove it.
In the real world, though, it simply doesn’t work that way. Investors, such as Warren Buffett, have consistently beaten the market over long periods of time, which by definition is impossible according to the EMH. The academics missed a key aspect of human nature: People tend to be irrational at times and get caught up in a herd mentality. It is human nature for people, even rational people, to act crazy from time to time. This is one of those times.
Markets can stay in these absurd, irrational states for a long time. There’s a great quote from the investor and author Jim Rogers that captures this idea. He said, “Markets often rise higher than you think is possible, and fall lower than you can possibly imagine.”
Speaking of Buffett and prices falling lower than you can imagine, Buffett was on TV recently saying he doesn’t see how you could go wrong buying solid companies with products people use every day. This is a true statement most of the time — but NOT now. Many, if not most, investors have been conditioned to “buy the dips,” and that has been the right move since the 2008 financial crisis, however, it is doubtful this will be the smart move ahead. The new smart move will be to “sell the rallies” rather than “buy the dips.” Buffett states, “You want to be greedy when others are fearful. You want to be fearful when others are greedy. It’s that simple.”
Here are some examples of how the stock prices of some large, well known and extremely successful companies fared during the 1929 stock market crash – and remember, these are the companies which survived, thousands of companies went bankrupt:
AT&T’s stock peaked in 1929 at $51 and fell 81% in three years! It took 31 years to get back to $51 per share. This was at a time when it had a monopoly on phone service in the U.S.
General Motors stock hit $395 in late 1928 and then fell to $4 in 1932. It was still down 67% in 1938 and didn’t hit new highs until 1950, 22 years later.
Sears & Roebuck, the greatest retailer of its time, went from a high of $48 per share and fell to as low as $2.50, for a decline of 95%. It didn’t hit its old high until 1946.
The current top is a bigger top than 1929 so the declines will be greater and the number of companies going bankrupt will exceed those going bankrupt in the 1930’s.
The bullish consensus is at an extreme. Everyone thinks they want to be contrarian, yet it is very hard to be one; it’s uncomfortable. If you are bearish on the stock market when nearly all are bullish, you are considered full of negativity, or even anti-American. Investors with the courage to buck the trend — to stand apart from the crowd — are the ones who generate the greatest returns on their money.
Those who buck this trend are setting themselves up for very large profits in 2015. The payoff is coming, even if we have to wait a little to see results.
Home prices peaked eight years ago, commodities six years ago, and precious metals topped three years ago. Other than Asian stock markets (which are in a bull market) and some relatively small, niche markets, Western blue-chip stock markets were the only major exception to the deflationary depression forces. It now appears the DJIA and S&P 500 have finally topped.
It cannot be emphasized enough how bad the coming market crash, and resulting economic impact, will be; Doug Casey is calling for the “Greater Depression” (worse than the 1930’s), Jim Rickards is referring to the next 10 years as our “Nation’s Darkest Decade.” Though there is agreement on the imminent market crash, they give too much credence to an inflationary crash. Robert Pretcher’s book, “Conquer the Crash,” calling for a deflationary depression is likely much more accurate.
Last week, in a single day, the Shanghai (China) Composite Index fell 5.4% and Athens (Greece) Stock Exchange fell a record 12.9%. This is a glimpse into the future.
The first wave down in the DJIA erased nearly 1000 points in only seven trading days. The current bounce underway should rise to at least 17,500, maybe as high as 17,800, but don’t get greedy. There is a seasonal bullish bias near holidays and there could be some more year end “window dressing” with money managers buying stocks which have performed well and selling those which have not, however, surprises will be to the downside; don’t wait. Now that the top is confirmed, use the current rally to unload your long stock holdings and get positioned for a severe bear market.
It is recommended you double down on the previous short stock recommendations from the August 18 post, so invest twice your normal position size in the following stocks:
Short SPDR Barclays Capital High Yield Bond ETF (JNK). Current price is $38.17 and the three year price projection is below $5.
Short iShares U.S. Real Estate EFT (IYR). Current price is $76.88 and the three year target is less than $10.
Short KWB Bank Index (BKX). Currently at $72.08 and it should easily go below $15 in the next three years.
Short Financial Select Sector SPDR Fund (XLF). Current price is $24.23 and should easily go below $5 within the next three years.
Short iShares Russell 2000 Index Fund (IWM). Current price is $116.89 and three year target is below $20.
Please note these prices should be considered limit prices as the prices you should receive in the next day or two should be better than today’s closing prices. Also note that when shorting stock, you only have to put up 50% of the value of the stock, e.g., if shorting a $100 stock, you only need to put up $50, so if the stock drops in value from $100 to $50, you make 100% on your money.
For speculators only, here are some option trades:
Buy ½ position size of the NASDAQ 100 (QQQ) put options, with a strike price of 100, expiring on March 19, 2015. The last trade was at $3.35, but since the bear market rally has a little more to go, place a limit order to buy at $3.00. The standard option contract is for 100 shares, so one option (covering 100 QQQ shares) will cost $300 (plus commissions).
Buy another ½ position size of the NASDAQ 100 (QQQ) put options, with a strike price of 95, expiring June 18, 2015. The current ask price is $3.55. Place a limit order to buy at $3.30.
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