The past two weeks have seen four of the top 10 most volatile trading days of the year, raising concerns that the market’s advance may be ending.
Whether that is true or not, no doubt volatility has increased as the Volatility S&P 500 (VIX) is back above the 17 level — something it has done only 14 of the 195 trading days thus far in 2014. Contrast that to it spending 79% and 154 days of the year below the 15 level, suggesting all is well with the market.
Volatility is increasing and that is a reason to be cautious. But, how do we know when downside risk is really increasing?
Combining Common Sense With Reality
At ETFguide we tackle the markets through a four-pronged approach.
While most of Wall Street focuses solely on fundamentals we believe the markets have proven time and again that they are driven by much more than just earnings. Some may even say, fundamentals have little to do with today’s market, and there certainly is plenty of evidence for that.
At a bare minimum we should admit that there are times when fundamentals do prevail. But there are also times when other market dynamics prevail.
As we have shown through many examples to our subscribers, today’s market is a perfect example of why utilizing all four methods instead of just one will help you keep your sanity.
The Reality Is…
In our view the fundamentals are not currently driving the market, and they haven’t for awhile.
Take for instance the fact S&P 500 earnings are growing less than 3% per year since 2007’s market top along with revenue growth of only 1% per year during the same time, meanwhile the market is rising at an above average rate.
My article, “earnings growth still below historical norms” dives into these details, but it is hard to argue the market just rose at one of the fastest rates in history while earnings are growing at some of the slowest rates in history and not conclude that something else is driving market prices higher.
Strategas Partners sums up what really occurs in the markets and why following fundamentals alone can really leave you hanging most of the time. The analysis suggests that since 1957, price-to-earnings multiple expansion has driven the S&P’s price 70% of the time while earnings is only 30% of the equation.
As an example, in 2011 full year S&P earnings were $86.95. 2012’s full year earnings were just $86.51. So after one year, earnings growth was slightly negative, yet the S&P rose 13% that year. Multiple expansion drove the entire advancement of the market.
But what is “multiple expansion” really?
Earnings takes care of the “E” in the P/E equation, but what takes into account for the multiple expansion, and, “Price” portion of the P/E equation?
This is where the other 3 prongs come into play.
Sentiment and Technicals
Not all of finance and investing is objective.
There is a major subjective piece that the “multiple expansion” topic attempts to capture, but this alone doesn’t explain why multiples still “expand” and “contract”.
We chalk that ebb and flow up to investor sentiment and behavioral finance.
Our subscribers already know that sentiment measures going back decades have already reached bullish extremes, no doubt a reason this bull has rallied so far for so long as advisors, newsletters, and money managers are as long the markets as they have ever been. But, our subscribers also know that these sentiment readings are extremely cyclical, ebbing from extremely bullish to extremely bearish following the markets’ trends.
Can you take a guess of what these sentiment measurements read when market tops typically occur and what they read near market bottoms. Let’s just say that these readings suggest the market is much closer to a top than a bottom.
But, although sentiment remains extremely bullish as investors are already “all in” and the fundamentals do not support the market’s advancement, price continues to rise. Why?
The charts help nail down why the market continues to advance.
Charts Keep You Sane
Check out the chart below.
First, let’s use a little common sense. Does now look like the right time to buy? What do you expect the upside to be? What’s your downside risk?
Obviously it is almost always better in hindsight to buy stocks when they were lower in price, but all that is now in the past and we must work from the present. What about buying right now?
You could, but based on our analysis above the only thing keeping this bull alive is its upward momentum and technical trend. Even statistics aren’t on the side of bulls as we are already in the midst of one of the longest periods ever without even a 10% market correction. Do you feel comfortable challenging those odds?
With sentiment also suggesting a historically extreme amount of bulls already long and fundamentals certainly not helping with their historically slow top and bottom line growth rates, this leaves just the technical trend to help us with our decision.
If you buy now, let me be the first to suggest getting out once the technical trend suggested by the chart above changes.
A similar chart of the Russell 2000 small cap index shows its trend has already started to change and is one reason we provided our subscribers on Oct. 8 in our Weekly Pick the suggestion to buy the inverse Russell 2000 ETF (RWM). With the Russell 2000 down around 2% on Thursday, Oct. 9, that trade is already up around 2%.
Everyone knows something is fishy about the current bull market. In our opinion, the primary driver at this point is good ole fashion speculation and short-term trading. Once the trend, now being held up solely by speculation, finally does turn, just like 1999 and 2007 and outlined in the chart above, the fall from grace may be swift and painful. That leaves plenty of upside for properly positioned money.
All that is left for this market to hold its hopes on is the technical trend. Once that inevitably fails, the rush to the exits will likely catch the historically extreme amount of bulls off guard and in a panic as they seem to think the Fed will always be there to save them even though history time and again shows this not to be the case.
The ETF Profit Strategy Newsletter uses fundamental, technical, and sentiment analysis coupled with common sense. Some major markets have already broken their five-year uptrends and is why those markets are having a very tough time of late. Is the S&P next?
Follow us on Twitter @ ETFguide.
More From InvestorPlace