How the Smart Money Is Preparing for the Next Financial Storm

A little trickle like the coronavirus could turn into a flood, so investors should be paying attention

The coronavirus continues to fan out around the world, sickening thousands of people along the way.

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The deadly epidemic, which first appeared in the city of Wuhan, has now spread to all 31 Chinese provinces and 25 other countries, including the United States.

Not surprisingly, world stock markets have become rather sickly as well.

So is this the end? Does the Wuhan coronavirus spell the end of the decade-long bull market we’ve been enjoying?

Probably not.

But here’s the thing …

Every flood begins with a trickle.

And every bear market begins with warning signs that most financial experts ignore.

Today, for example, investment capital is trickling out of small-cap stocks, even though many large-cap stocks are still climbing to all-time highs. If this trickle from the small-cap sector becomes a flood, most investors may quickly find themselves underwater.

Deep underwater.

Not every trickle leads to a flood, of course. But a trickle that springs from the foundation of an intensely pressurized structure — such as a financial market — deserves attention.

Springing a Leak

At a glance, this immense $31 trillion market seems as robust as it is colossal. It is, after all, the largest and most liquid financial market on the planet. But on closer inspection, this market may be resting on a feeble foundation.

The small-cap sector, for example, has sprung a leak. The S&P SmallCap 600 index topped out in August 2018 and has slipped 7% since then, even though the S&P 500 has continued moving higher and making new all-time highs.

The failure of small-cap stocks to advance in unison with their large-cap counterparts is not always a bad sign, but it is never a good one. Technical analysts describe this phenomenon as a “bearish divergence” that often portends overall stock market weakness.

Another sort of bearish divergence is also signaling trouble ahead: The “new highs” list has been contracting for nearly two years. The “new highs” list tracks the weekly tally of stocks on U.S. exchanges that are hitting new 52-week highs.

Generally speaking, a “healthy” stock market produces a rising number of new highs as it marches higher, whereas an unhealthy stock market produces a contracting number of new highs.

Technical analysts refer to the latter phenomenon as “narrow participation”… and it is never a positive sign.

Source: InvestorPlace

The contracting new highs list and the capital flight from the small-cap sector are not the only troubling signs for the stock market. A few other ominous omens include:

  • An inverted yield curve. That’s when short-term bonds are yielding more than long-term bonds. This rare configuration, which often signals a coming recession, developed early in 2019 for the first time since the 2007-08 crisis. It remains inverted today.
  • A poorly performing transportation sector. According to Dow theory — and more than 135 years of market history — a weak transportation sector often portends a broad market downtrend. After topping out in September 2018, the Dow Jones Transportation Average is down 7% from that high.
  • A reviving precious metals sector. As the ultimate anti-stock asset, precious metals often strengthen when stock prices stumble. It is somewhat concerning, therefore, that the price of gold, and gold stocks, both started making a major move higher in the summer of 2018 — the exact same moment when the S&P SmallCap 600 and the Dow Transportation Average hit their all-time highs. Since mid-August 2018, gold has produced double the gains of the S&P 500, while gold stocks have produced triple the gain.
Source: InvestorPlace

Moving away from the financial markets to the real economy, warning signs are also proliferating. Let’s take a look at just one of them, the Institute for Supply Management (ISM) Manufacturing Index, which measures manufacturing activity in the U.S.

Readings from this index topped out one year ago and have been falling sharply ever since. The ISM Manufacturing Index has tumbled 21% since August 2018. Drops of this speed and magnitude tend to precede or coincide with steep stock market selloffs, as occurred in 2000 and 2008.

Source: InvestorPlace

And yet, even when warning signs like these accumulate, investors tend to dismiss them as harmless, “normal” features of a healthy financial market. Most of us never see a bear market coming until it has already launched its initial attack on our portfolios. In fact, professional investors are often just as blind to risk as novice investors.

As investing legend Peter Lynch once observed, “I don’t remember anybody predicting the market right more than once.”

Today’s accepted wisdom embraces the belief that stock prices are likely to keep moving higher. Investors might not be wildly in love with stocks, but they certainly like-like them … a whole bunch.

And generally speaking, they harbor little fear of a major selloff. After all, the stock market has been rising for the last 10 years.

So what’s to fear?

When Cash Is King

The chart below provides a partial answer. Based on price-to-EBITDA (that is, gross earnings), the S&P 500 is trading close to a record-high level. That’s not a good sign, as richly valued stocks tend to produce sub-par investment results.

Source: InvestorPlace

For example, if the S&P 500 merely dipped from its current valuation to its average price-to-EBITDA valuation of the last three decades, it would fall more than 30%.

But once a stock market begins a major decline, it rarely stops falling at the “average” level. Instead, it continues to fall and overshoots on the downside.

In other words, when stocks become this pricey, good things rarely happen. Conversely, good things often happen to lowly valued stocks. The chart below illustrates this inverse relationship.

Source: InvestorPlace

For example, in 1994, the blue line shows that U.S. stocks were selling for only 5.2 times EBITDA — or less than half today’s valuation. From that low starting point, the orange line shows that the S&P 500 delivered a total return of 247% during the ensuing five years (from 1994 to 1999).

But as U.S. stocks soared toward their 1999 highs, they reached a rich valuation of 11.2 times EBITDA. That was the record-high reading on this indicator … until recently.

Not surprisingly, from that lofty starting point, the next five years in the stock market were a complete bust. The S&P 500 produced a loss of 11%. In fact, even 10 years after that high-valuation reading of 1999, the S&P 500 was still 9% underwater.

In other words, after one entire decade of investment, the stock market turned $100 into $91.

Clearly, the starting price matters when making an investment. That’s why buying U.S. stocks at their current lofty valuations could be a risky bet. Today’s high price-to-EBITDA reading is certainly a warning sign — a sign to lighten up on stocks and build up your cash holdings.

Cash is the only asset that truly protects your capital during a market selloff.

As I pointed out in my book, Bear Market 2020: The Survival Blueprint, cash occupies a unique place in the world of investing.

That’s why I suggest raising modest amounts of cash at moments like these, when warning signs are multiplying and valuations are hovering near historically high levels.

But even as you raise some cash and boost your exposure to precious metals, you should not abandon your core long-term investments.

Reducing exposure to stocks doesn’t mean eliminating exposure to them. As we guard against bear market losses, we must remain focused on our long-term investment objectives.

Cash is just one of the tactics I go over in Bear Market 2020: The Survival Blueprint. In it, I outline what I believe are the seven essential tactics every American should take right now, before things take a turn for the worse. To find out how to get my book, click here.

P.S. Folks spend their entire lives saving for retirement, but very few ever spend time thinking about how to protect their capital when things go south. Even a relatively minor decline of 20% could set your retirement back several years or more. That’s why, for a limited time, I’d like to rush you a copy of my new book, Bear Market 2020: The Survival Blueprint.

When it comes to the stock market, the biggest mistake most people are making right now is … doing nothing. Don’t wait for the news media to tell you the stock market has fallen by 20%. By then it will be too late. Learn how to claim your copy of Bear Market 2020 by clicking here.

Eric Fry is an award-winning stock picker with numerous “10-bagger” calls — in good markets AND bad. How? By finding potent global megatrends … before they take off. And when it comes to bear markets, you’ll want to have his “blueprint” in hand before stocks go south. Eric does not own the aforementioned securities.

Article printed from InvestorPlace Media,

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