Is a US sharemarket correction coming? Here are the signs of investor euphoria. by Michael McCarthy "Bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria." – Sir John Templeton In the computer age most investors rely exclusively on quantitative analysis. Whether it's GDP and CPI data, company earnings results or chart-based assessments, it's the numbers that count.
It's understandable. Numbers are by definition precise, and easily compared one with another. But the numbers rarely help when it comes to one of the most important market calls. Picking the market sea change from bull to bear market – and preparing accordingly – is a key to capital preservation and long-term investment success.
The difficulty with the focus on numbers is that they often lag the turn in the market. Unlike bull markets that unfold over months and years, sharemarket sell-downs can materialise suddenly, and degenerate quickly.
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It's one reason investors are prepared to listen to the perpetual prophets of doom. Despite the fact that some analysts have called for a "hard landing" or credit crunch in China for a decade, their solemn declarations of impending disaster still get a hearing.
The same is true of the long-touted meltdown in Australian housing markets and bank share prices. Over the same period many commentators have called a premature end to one of the longest bull runs in the US sharemarket in history.
But looking at the wise words of legendary investor Sir John Templeton, there are qualitative signs that US stocks could be headed for trouble. Longer-term investors may look for signs of euphoria as an indication a turn may be imminent.
Consider this August 30 tweet by the president of the United States: "For all of you that have made a fortune in the markets, or seen your 401ks rise beyond your wildest expectations, more good news is coming!" The US S&P 500 index is up more than 330 per cent in nine years. As the market hovers near its all-time highs, the White House is ramping up optimism. This was met with barely contained glee in certain investment circles.
Some may see this as a marker of a sentiment shift into euphoria. Other signs Further evidence lies in market responses to bad news. Interest-rate markets in the US are indicating a 100 per cent probability of a lift in official US interest rates on September 26 (that’s today!), and a more than 70 per cent chance of a further rise in December.
Higher interest rates hurt corporate bottom lines and stock valuations, yet US investors continue to buy. The recent escalation of the trade dispute between China and the US is almost certain to slow global growth, but it seems even that can't stop the bull.
Energy is a key industrial input. Oil prices are back to four-year highs. The investor response is to buy energy shares.
These positive reactions to developments that at other times in the sharemarket cycle could provoke selling are another possible symptom of investor euphoria.
Anticipating the trigger for a market correction is also a fraught practice. Nevertheless there are two potential firestarters on the near horizon. One is the US mid-term elections in the first week of November. If control of either house of the US Congress passes to the Democrats, the further stimulatory legislation markets are expecting from the Republican Party is imperilled. This may see growth assumptions slashed, and share prices with them.
The other possible trigger is the US bond market. Ten-year bond prices are at seven-year lows. Bond yields move in the opposite direction to prices. If the 10-year yield moves up through the highs at 3.126 per cent it may spark a rout, and it rose to just a few basis points away from this level last week. There are about $US15.5 trillion ($21.4 trillion) of US government bonds in private and international hands, and the largest international holders are China and Japan. Selling of US bonds may be a rational response to escalating trade concerns.
The problem with qualitative measures is they are notoriously poor at predicting timing. All of this may come to nought. Concerned investors can still take action. One possible course is to maintain portfolios and buy put options.
If markets continue to rise, investors may lose the premium paid for the puts, but gain on their shareholdings. However, if markets do tank, the value of put options is likely to explode, potentially offsetting portfolio losses. Michael McCarthy is chief market strategist at CMC Markets.
Harry Dent writes I always consider two scenarios when doing any kind of short-term forecasting. In short, that’s because there are so many more variables that could affect outcomes in the short term that, really, things could go either way.
So here’s an update on the two scenarios we could see from here.
In Scenario One we could see a major top soon or in the next few months and then a major crash in the US economy — greater than what we endured in 2008 — could begin by late this year.
In Scenario Two — which I still believe could be the more likely — we would see one more leg up in this Trump Rally and then a final blow-off in 2019. First though, we would likely see a normal correction just ahead.
On Friday, the Dow Jones Industrials finally joined most other major indices in making new highs. This is a bullish confirmation near term and another feather in the cap for Scenario Two. It would suggest several more months of rallying.
The late January peak we saw this year did look very much like the crescendo of a blow-off top, but we didn’t see that classic 40%-plus crash in the first three months that follows such major bubble tops.
We’ve seen one index after the next make new highs: The Russell 2000 (small-caps) in mid-May, the NASDAQ in early June, the S&P 500 and Dow Transports in late August, and now the Dow Industrials.
Only two major indices have not yet accomplished this feat: the Dow Utilities, which is still 7% off the all-time high, and the broadest NYSE, which is 3% below its high. There is still a little danger from those non-confirmations.
Here’s the update to my S&P 500 Channel…
As you can see in the chart, there’s a resistance level at my first target at the top trend-line around 3,050 a few months from now, or 2,960 very near term on the S&P 500. And, as we did in January, we could go over that a bit.
There’s a short-term rising wedge since May that would also peak around these same targets just ahead or a few months from now. Hence, some level of a correction looks very likely just ahead.
The China trade war has continued to heat up.
Trump continues to face political and legal challenges.
The Democrats could take the House and the Senate.
The million-dollar question is: Do we see the big peak just ahead? Or do we see a more normal 10% or 15% correction, with support at the bottom trend-line of this channel (or at worst at the February lows of this year) with the final peak hitting late in 2019?
I’m inclined towards the latter because most technical indicators like the advance/decline line and the inverted yield curve are still more bullish, albeit getting less so.
However, the smart money flow index is very bearish, and we’ve just seen the 16th Hindenburg Omen in the last few weeks. It warns a crash could happen. Every past crash has seen this omen trigger before the wheels came off…but many Hindenburg Omens have not resulted in a crash. Still, 16 omens, 14 of them consecutively? That suggests caution is warranted.
If we don’t see a major crash by late February, the odds would clearly favour Scenario Two. After that, going on the ‘Great Bubble Buster’ 90-year cycle, by my reckoning the next major crash could hit hardest in late 2019.
