Major Stock Bear Still Looms

Stock-price levels are ultimately dependent on underlying corporate profits, truly their sole fundamental foundation. Profits tend to rise gradually over time in fairly-linear fashion. But bulls and bears, fueled by widespread greed and fear respectively, temporarily drag stock prices away from their righteous fair values derived from earnings. These emotional distortions never last, as stocks always revert to mean valuations.

Today stock euphoria is rampant deep in the second-longest bull market in US history. And the driving catalyst couldn’t be stranger, Donald Trump’s surprise win of the US presidency. Leading up to early November’s election, stock markets sold off every time Trump’s odds of winning seemed to rise. Then on election night as Trump’s Florida lead mounted, stock-index futures plummeted limit-down to 5% losses!

Yet within hours after it became clear the election results wouldn’t be contested, stock traders’ sentiment turned on a dime. Instead of fearing Trump the unknown loose cannon, they whole-heartedly embraced his policy agenda. The prospects of huge corporate-income-tax and personal-income-tax cuts, on top of massive new infrastructure spending, left stock traders salivating at potential much-higher future profits.

So they rushed to buy stocks in the wake of Trump’s surprise victory, catapulting the stock markets to a series of new all-time record highs. These naturally ignited widespread popular greed and euphoria. As 2016 ends, investors expect nothing but blue skies coming. But the near-bubble valuations stocks were trading at even before the election argues the opposite, that dark storm clouds are building ready to unleash hell.

Rather ironically Trump himself, stock traders’ newly-crowned savior of the stock markets, often warned about these dangerous stock markets during his campaign. Trump spoke to his biggest audience ever back in late September during the first US presidential debate, and he couldn’t have made his outlook on the stock markets any clearer. Trump admonished, “Believe me, we are in a bubble right now…”

“…and the only thing that looks good is the stock market, but if you raise interest rates even a little bit, that’s going to come crashing down. We are in a big, fat, ugly bubble.” And valuations now in the wake of the post-election euphoria are even more extreme than they were several months ago when Trump somberly warned American voters about the stock-market dangers! Stocks are an accident waiting to happen.

Heading into 2017, all investors desperately need to understand how exceedingly risky these lofty stock markets are. A major stock bear still looms despite recent months’ sharp rallies to new record highs, and all the jubilation that goes along with that. While the primary reason is today’s literally bubble valuations the stock markets are trading at, many other bearish factors are also converging. The downside risk is great.

While it would take books to fully explain all this, the best place to start is with a brief history of this stock bull. This bull market is the most anomalous in US history, with the majority artificially conjured by a Fed hellbent on extreme easing! This first chart looks at the flagship Standard & Poor’s 500 (SPX) broad-market stock index, along with its definitive sentiment gauge the VIX S&P 500 implied-volatility index.

This amazing stock bull was born way back in March 2009 in the wake of the first true stock panic since 1907. After such an epic maelstrom of fear fueled such an extreme plummet to climax a bear market, a new bull was indeed overdue despite rampant bearishness and pessimism. The very trading day before the SPX bottomed, I wrote a hardcore contrarian essay explaining why a major new bull market was being born.

Back in early 2009 stock-market valuations were so low after the panic that a new bull was fully justified fundamentally. And its first four years or so played out perfectly normally. Between early 2009 and late 2012, this bull market’s trajectory was normal. It rocketed higher initially out of deep bear lows, but those gains moderated as this bull matured. And its upside progress was punctuated by healthy major corrections.

Stock-market selloffs are generally defined in set ranges. Anything under 4% isn’t worth classifying, it is just normal market noise. Then from 4% to 10%, selloffs become pullbacks. Beyond that in the 10%-to-20% range are corrections. Selloffs greater than 20% are formally considered new bear markets. In both 2010 and 2011 the SPX suffered major corrections in the upper teens, which are essential to rebalance sentiment.

As bull markets power higher, greed naturally grows among investors and speculators. They start to get very complacent and expect higher stocks indefinitely. Eventually this metastasizes into euphoria and even hubris. Major corrections, big and sharp mid-bull selloffs, rekindle fear to offset excessive greed and keep bulls healthy. Interestingly even in 2010 and 2011 the Fed played a key role in stock-market timing.

Those early bull years’ major corrections coincided exactly with the ends of the Fed’s first and second quantitative-easing campaigns. QE is an extreme monetary-policy measure central banks can use after they force interest rates, their normal tool, down to zero. The Fed’s zero-interest-rate policy went live in mid-December 2008 in response to that first stock panic in a century, and QE1 and QE2 soon followed.

Quantitative easing involves creating new money out of thin air to buy up bonds, effectively monetizing debt. While QE1 and QE2 certainly caused market distortions, both campaigns had predetermined sizes and durations. When traders knew a particular QE campaign was nearing its end, they started selling stocks which drove the major corrections. So the Fed decided to change tactics when it launched QE3.

As the SPX approached 1450 in late 2012, that normal stock-market bull was topping due to expensive valuations. After peaking in April, stock markets started rolling over heading into that year’s presidential election. Stock-market fortunes in the final several months leading into elections can greatly sway their outcomes. So in mid-September 2012 less than 8 weeks before the election, a hyper-political Fed birthed QE3.

QE3 was radically different from QE1 and QE2 in that it was totally open-ended. Unlike its predecessors, QE3 had no predetermined size or duration! So stock traders couldn’t anticipate when QE3 would end or how big it would get. Stock markets surged on QE3’s announcement and subsequent expansion a few months later. Fed officials started to deftly use QE3’s inherent ambiguity to herd stock traders’ psychology.

Whenever the stock markets started to sell off, Fed officials would rush to their microphones to reassure traders that QE3 could be expanded anytime if necessary. Those implicit promises of central-bank intervention quickly truncated all nascent selloffs before they could reach correction territory. Traders realized that the Fed was effectively backstopping the stock markets! So greed flourished unchecked by corrections.

This stock bull went from normal between 2009 and 2012 to literally central-bank conjured from 2013 on! The Fed’s QE3-expansion promises so enthralled traders that the SPX went an astounding 3.6 years without a correction between late 2011 and mid-2015, one of the longest-such spans ever. With the Fed jawboning negating healthy sentiment-rebalancing corrections, sentiment grew ever more greedy and complacent.

QE3 was finally wound down in late 2014, leading to the Fed-conjured stock bull stalling out. Without central-bank money printing behind it, the stock-market levitation between 2013 and 2015 never would have happened! One of the most-damning charts of recent years shows the SPX perfectly tracking the growth in the Fed’s balance sheet as its monetized bonds accumulated there. This stock bull is largely fake.

Without the Fed’s QE firehose blasting new money into the system, stock-market corrections resumed in mid-2015 and early 2016. After topping in May 2015 not much higher than QE3-ending levels, the SPX drifted sideways to lower for fully 13.7 months. That too should’ve proven this artificially-extended bull’s top, giving way to the overdue subsequent bear. But that was miraculously short-circuited by the Brexit vote.

Heading into late June this year, Wall Street was forecasting a sharp global stock-market selloff if British people actually voted to leave the EU. What was seen as a low-probability outcome promised to unleash all kinds of uncertainty and chaos. And indeed when the Brexit vote surprised and passed, the SPX fell sharply for a couple trading days. Then meddling central banks stepped in assuring they were ready to intervene.

So this tired old bull again started surging to new record highs in July and August, although they were not much better than May 2015’s. After that euphoric surge on hopes for post-Brexit-vote central-bank easing, the SPX started to roll over again heading into the US presidential election. Again Wall Street warned just like Brexit that a Trump win would ignite a major stock-market selloff, and again proved dead wrong.

The shocking post-election stock surge has been called a Trumpgasm, or Trumphoria. Capital flooded into stocks for a variety of reasons. In addition to hopes of far-better government policies boosting corporate profits, funds rushed to buy to chase good year-end gains to report to their investors. And the resulting record stock-market highs, and hopes for big economic changes, are even bringing individual investors back.

So by mid-December, this anomalous bull market in SPX terms extended to an epic 235.8% gain over 7.8 years! That is one of the biggest and longest bull-market spans in US history, exceptional in every way. The problem is its foundations are totally rotten, underlying corporate earnings never supported such lofty stock prices. While stocks soared mostly on extreme Fed easing, profits growth stagnated.

Before we delve into these stock markets’ dangerous bubble valuations, consider the radical complacency the post-election surge generated. That definitive VIX fear gauge collapsed back into the 11s, about as low as it ever gets. Note in the chart above that big selloffs erupt from low VIX levels revealing stellar complacency and non-existent fear. The stock markets are ripe for a major selloff regardless of valuations.

And investors aren’t taking the threat of a new bear seriously. Crossing the bear threshold just requires a 20% retreat. Even such a baby bear would erase all SPX gains since late 2013. A normal bear market at this stage in the Long Valuation Waves is actually 50%, cutting stock prices in half! That would erase the great majority of this entire mighty stock bull, dragging the SPX all the way back down to early-2010 levels.

Even more ominously, bear markets naturally following bulls tend to be proportional. That makes sense since bears’ job is to rebalance sentiment and work off overvalued conditions. So there’s a high chance the coming bear after such an anomalous Fed-goosed bull won’t stop at 50%. The downside risks from here are utterly mindboggling after such a long bull driven by extreme central-bank easing instead of profits.

And that finally brings us to valuations, this old stock bull’s core problem. This next chart looks at the SPX superimposed over a couple key valuation metrics. Both are derived from averaging the trailing-twelve-month price-to-earnings ratios of all 500 elite SPX companies. The light-blue line is their simple average, while the dark-blue one is weighted by market capitalization. Today’s valuations ought to terrify investors.

Unfortunately today corporate earnings are intentionally obscured by Wall Street to mask the dangerous overvaluation that is rampant. Analysts make up blatant fictions including forward earnings, which are literally guesses about what companies will earn in the coming year. These almost always prove wildly optimistic. Analysts also look at adjusted earnings, another Pollyannaish farce where companies ignore expenses.

Wall Street also plays a deceptive estimate game to make quarterly-earnings results look way better than they really are. Instead of comparing actual hard quarterly profits with the same quarter a year earlier, they intentionally lowball estimates so companies beat regardless of their actual earnings trend. Investors are being bamboozled, with the only honest way of measuring corporate profits buried and forgotten.

That is based on generally-accepted accounting principles (GAAP) which are required when companies actually report to regulators. The only righteous way to measure price-to-earnings ratios is using the last four quarters of GAAP profits, or trailing twelve months. Those numbers are hard, established in the real world based on real sales and real expenses. They are not mere estimates like totally-bogus forward earnings.

Every month at Zeal we look at the TTM P/Es of all 500 SPX companies. At the end of November, the simple average of all SPX companies actually earning profits so they can have P/Es was an astounding 28.1x! That is formally in bubble territory, just as Trump warned about during the campaign. 14x earnings is the historical fair value over a century and a quarter, and double that at 28x is where bubble levels start.

If you study the history of the stock markets, stock prices never do well starting from bubble valuations. Such extreme stock prices relative to underlying corporate earnings streams actually herald the birth of major new bear markets. Again they usually cut stock prices in half. So buying stocks here, late in an old bull market artificially levitated by the Fed, is the height of folly. Massive losses are inevitably coming.

Remember stock markets perpetually meander through alternating bull-bear cycles. Back in late 2012 before the Fed stepped in to try and brazenly short-circuit these valuation-driven cycles, valuations were actually in a secular-bear downtrend. After secular bulls drive valuations to bubble extremes, with greed forcing stock prices far beyond underlying corporate earnings, secular bears emerge to reverse these excesses.

During secular bears, stock prices grind sideways on balance for long enough for earnings to catch up with lofty stock prices. Before QE3 temporarily broke stock-market cycles, that process had been happening as normal between 2000 and 2012. Secular bears don’t end until valuations get to half fair value, 7x earnings. So instead of being near bubble levels, valuations would normally be between 7x to 10x today.

That’s the massive downside risk stocks face due to their Fed-conjured bubble valuations! While the red line above shows the actual SPX, the white line shows where it would be trading at 14x fair value. Even that is way down around 1207 today, roughly half current levels. But mean reversions from extremes nearly always overshoot in the opposite direction, so the potential SPX bear-market bottom is much lower.

Sadly Wall Street will never bother telling investors that valuations matter. Stock-market history proves beyond all doubt that buying stocks high in valuation terms nearly always leads to considerable-to-huge losses. All the financial industry cares about is keeping people fully invested no matter what, since that maximizes their fees derived from percentages of assets under management. Talk about a conflict of interest!

The more expensive stocks are in valuation terms when they are purchased, the worse the subsequent returns will be. And no matter how awesome Trump’s policies may ultimately prove, they aren’t going to rescue corporate profits anytime soon. Even if everything miraculously goes perfectly, the major tax cuts being discussed aren’t coming until 2018 at best. Even infrastructure spending takes some time to ramp up.

In the meantime, corporate profits face major headwinds in the coming quarters that are likely to leave stock valuations even more extreme. Part of the Trumphoria after the election catapulted the US Dollar Index to lofty new 14.0-year secular highs. About half of the revenues for the 500 SPX companies as a whole come from overseas, so overall profits are going to get hit hard starting in Q4’16 due to the strong dollar.

High US-dollar levels make the products and services US companies are selling in foreign countries a lot more expensive, retarding sales. And then the resulting foreign profits are hit again on translation back into US dollars. So the imminent Q4’16 earnings season isn’t likely to look good at all, although Wall Street will try to mask that as usual with expectations games instead of hard year-over-year analysis.

The stock markets’ lofty valuations before the Trumpgasm and bubble valuations since are a very serious problem that can only be resolved by an overdue major bear market. Only that will drag stock prices low enough to where existing and future corporate earnings will support reasonable valuations again. Realize as well that the Republicans now dominating government have every incentive to let stocks fall in 2017.

As Trump often pointed out, they know stocks are dangerously overpriced due to their artificial levitation by the Fed in recent years. The sooner the inevitable stock bear to fix this begins, the sooner it will end. There is a narrow window here where the stock bear can still be blamed on Obama’s policies. There’s no doubt the Republicans in power want it out of the way before the 2018 elections and especially the 2020 ones.

Early in new presidencies is the best time politically, the least damaging, to see weak stock markets. As Republicans now control the majorities in both the Senate and House as well as the presidency, they have huge incentives to get the overdue stock bear out of the way as soon as possible. That way they can ride the subsequent bull into the next elections. So Washington’s support of this fake bull is likely finished.

Investors really need to lighten up on their stock-heavy portfolios, or put stop losses in place, to protect themselves from the coming valuation mean reversion in the form of a major new stock bear. Cash is king in bear markets, as its buying power increases as stock prices fall. Investors who hold cash during a 50% bear market can double their stock holdings at the bottom by buying back their stocks at half price!

Put options on the leading SPY S&P 500 ETF can be used to hedge downside risks. They are cheap now with euphoria rampant, but their prices will surge quickly when stocks start selling off materially. Even better than cash and SPY puts is gold, the anti-stock trade. Gold is a rare asset that tends to move counter to stock markets, leading to soaring investment demand for portfolio diversification when stocks fall.

Gold surged nearly 30% higher in the first half of 2016 in a new bull run that was initially sparked by the last major correction in stock markets early this year. If the stock markets indeed roll over into a new bear in 2017, gold’s gains next year should be much greater. And they will be dwarfed by those of the best gold miners’ stocks, whose profits leverage gold’s gains. Gold stocks rocketed 182% higher in 2016’s first half!

Absolutely essential in bear markets is cultivating excellent contrarian intelligence sources. That’s our specialty at Zeal. After decades studying the markets and trading, we really walk the contrarian walk. We buy low when few others will so we can later sell high when few others can. While Wall Street will deny the coming stock-market bear all the way down, we will help you both understand it and prosper during it.

The bottom line is the stock markets are literally trading at bubble valuations thanks to the stunning post-election rally. Such lofty stock prices are risky anytime, but exceedingly dangerous late in an enormous bull market artificially extended by the Fed. A major new bear market is long overdue that will at least cut stock prices in half. And the new Republican government has every political incentive to encourage it soon.

Prudent investors have to overcome late 2016’s groupthink herd euphoria and protect themselves from what’s coming. That means lightening up on stocks, building cash, and buying gold. Central banks have a long history of trying and failing to eliminate stock-market cycles. The longer they are artificially suppressed, the worse the inevitable reckoning as the cycles resume with a vengeance. 2017 looks dangerous!