You DO Know the S&P 500 Is About to Bite It, Right?

EDITOR’S NOTE: Due to technical difficulties, Sam Collins will return with tomorrow’s Market Outlook.

If you happened to step into stocks in early November and hung on tight since then, congratulations. The S&P 500 — as measured using the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) — is up more than 13% since the Nov. 4 low, while the SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) is up a whopping 16% for anyone willing to buy into it the Friday before President Trump was elected.

You DO Know the S&P 500 Is About to Bite It, Right?

Both seem to still be going strong, too, shrugging off any threats to the rally with relative ease.

Just for the record, though, do know that any bullishness that’s materialized in the form of new investments is based on nothing more than hopes and wishes. There’s no underlying fundamental argument that makes sense of current prices for most stocks, and all stocks as a whole.

It’s an idea that tends to fall on deaf ears when the echoes of the entry into record-high territory are still ringing. Besides, whether you like his policies or not, there’s no denying Donald Trump is a pro-business president, and that’s got to be good for the market sooner than later.

Problem is, the market was already pushing its luck (valuation-wise) before the election. The big rally from the S&P 500 and the Dow Jones Industrial Average in the meantime has only made matters worse.

This can only end one way…. ugly.

Don’t misunderstand. There’s a distinct difference between a recession and a market correction. Indeed, there’s even a distinct difference between a bear market and a market correction. What’s looming ahead is neither a recession nor a bear market. It’s just a much-needed correction to bring prices back down to earth to better reflect trailing (and even projected) earnings.

The immediate follow-up question: Why must we suffer a pullback sooner than later?

The answer is, because history says so. And three pieces of data sum up how we’ve come too far, too fast, for our own good. In no certain order:

Bullish Sentiment Is Dangerously High

Today’s headlines alone would leave an investor no other choice but to conclude more gains are inevitable. MarketWatch’s featured story today is “This bullish stock signal has never been wrong – and it’s about to flash for 2017.” CNBC says “This is a Reagan-like rally and here’s how much higher stocks can go.” And these headlines are not only par for the course, they have been for a few days now. What’s missing are many — if any — commentaries expressing doubt.

When everyone is singing the same song and certain there’s no downside risk, it often means all the buyers are already in. With no new money coming in, a rally is out of gas.

Valuations Make No Sense

The prospect of Trump’s planned tax cuts should be good for corporate earnings. Investors, however, have priced in far too much of a premium based on a tax-policy overhaul that doesn’t even exist yet.

As of the latest look, the S&P 500 boasts trailing twelve-month income of $106.86 per share, translating into a trailing P/E of 22.1. On a forward-looking basis, the S&P 500 is expected to earn $130.66 over the course of the next four earnings seasons. That translates into a forward-looking P/E of 18.07. Both are well above historic norms, even when interest rates are phenomenally low (like they are now).

But the planned tax cuts will improve bottom lines? Yes, they will. It’s a question of how much.

Cowen & Co’s David Seaburg crunched the numbers, and suggests that, roughly, the S&P 500 adds $1.30 worth of annual earnings for every percentage-point reduction in tax rates. As he noted, reducing rates by an average of 10% adds a total of $13 worth of income to the index’s profits, which would push 2017’s expected income up to $143.66.

Even at that level, the S&P 500 is still trading at a forward-looking P/E of 16.4. That’s still above long-term norms, and founded on the assumption that the S&P 500 was ever really capable of earning $130.66 this year; the figure is consistently too high.

The release of the tax plan — whatever it may look like — may serve as a nasty reality check on just what kind of impact it may have.

Hedge Funds Are Buying Value Stocks

Last but not least, it’s a bit esoteric, but a powerful “tell” all the same. That is, after several quarters of betting against value stocks and betting on momentum stocks (usually growth stocks), hedge funds are starting to go long on value stocks again while they continue to buy high-momentum growth stocks.

It’s a huge risk. When hedge funds — part of the presumed “smart money” crowd — start chasing trends and have run out of more aggressive ideas, it’s often a sign there’s just nothing worth owning that’s left to buy.

Worse, the same herd mentality that has hedge fund managers buying anything and everything can augment the profit-taking once stocks do reach a top.

Bottom Line

While the stage may be set for a setback, what’s not yet clear is when one may materialize. As long as traders are convinced stocks can’t go down, they’ll continue to go up.

History is pretty clear on the matter though …. expect it when you least expect it. The market makes a point of never tipping its hand until it’s too late to do anything about it.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

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