Don’t let strong second-quarter economic growth and the stock market rebound from all the big sell-offs earlier this year fool you. This isn’t a time to put new money into stocks, have dubious trades on, or own stocks on margin. There may be trouble ahead.
Of course, no one can really predict what the market will do next. But you can identify when risks are elevated — and that’s the case now. Here are seven reasons why.
1. Rich sentiment
When everyone is bullish, there are fewer people left to buy your stocks and drive them higher. Overconfident investors are also more likely to be “surprised” by bad news — and panic and sell.
So the elevated mood of stock investors right now is not a great sign. We’re not at extremes yet, since not all sentiment measures are aligned. But we are circling.
The Ned Davis Research Crowd Sentiment Poll and Daily Trading Sentiment Composite are showing excessive or extreme optimism. Consumer optimism is near its highest level in more than a decade. That’s good for the economy. But high levels of consumer confidence often occur prior to stock market corrections.
The Investors Intelligence Bull/Bear Ratio has been hovering just under three. That’s not in the red-flag zone, which for me starts at four. But it is close — especially considering all the other warning signs for stocks. For perspective, this measure lies between one and five most of the time.
2. A market MRI shows poor health
High sentiment alone doesn’t mean a correction is coming. But combined with weak market internals, sentiment is a better magic eight ball.
Right now, market internals look sick. Even though the headline indexes — the S&P 500 SPX, +0.46% Dow Jones Industrial Average DJIA, +0.54% and Nasdaq Composite Index COMP, +0.12% are near new highs, fewer stocks are participating, says Bruce Bittles, a market technician and chief investment strategist at Baird. “Under the surface, the broad market continues to lag the averages,” he says. The averages are increasingly dependent on a narrowing list of stocks for support.
For example, even as the Nasdaq hit new highs in late July, only around half of Nasdaq stocks traded above their 200-day moving averages. As the S&P 500 approached new highs, the number of advancing stocks compared to those declining was flat. In short, market breadth has been too narrow to support the headline index strength. That’s not a good sign.
3. Train wreck season is on the way
September and October are the months for vicious sell-offs. That’s why they’re the months that typically produce the weakest gains.
This seasonal weakness is often more extreme during election years. Historically, the weakest part of the presidential election cycle is the months before the mid-term elections, says Bittles. Be warned: This seasonal weakness is often harder on small-cap stocks. But also note that September-October weakness is not guaranteed.
4. Valuations are rich
Valuation measures are never good market-timing tools. But they can tell you a lot about the odds of what will happen next. Right now, elevated valuations suggest limited upside. So why risk being super long stocks? Better to stick with core long-term positions.
Everyone knows how to compare the market’s price-to-earnings ratio with historical levels. But here’s a better approach, says James Paulsen, chief investment strategist at the Leuthold Group: Adjust valuation measures for inflation.
To do this, Paulsen takes the stock market’s earnings yield (market price divided by trailing earnings) and subtracts inflation (the consumer price index). This gives him the real earnings yield. “This has done a better job highlighting when the chance of negative returns is more pronounced,” says Paulsen.
Since this is based on the inverse of the P/E ratio, lower readings mean higher valuations. And whenever this real earnings yield moves into its lowest quartile, market returns for the next 12 months are mediocre, at best. And the odds of losses ramp up.
Right now, this measure is right on the cusp of the danger zone. The real earnings yield was recently 1.8%, given the S&P 500 earnings yield of 4.7% and inflation at 2.9%. That’s just shy of moving into the lowest quartile danger zone, which starts at 1.7%. It also happens to be the lowest reading of this bull market.
5. Labor shortages spark inflation
Even though unemployment has fallen sharply in the past two years, wage gains have been modest. This has created complacency about inflation. But that may soon change, which could hurt stocks.
The Fed’s July Beige Book cautioned about nationwide labor shortages across a wide range of jobs, from engineers and IT specialists, to truck drivers and factory workers.
It looks like this is finally forcing companies to pay more. The Labor Department just announced that its employment cost index rose 2.8% in the year to June. That was the biggest pay hike workers got in nearly a decade.
This isn’t surprising — and you can expect more to come — for two reasons.
• Whenever GDP growth exceeds the unemployment rate, workers normally get healthy wage hikes. Since the fourth quarter, nominal GDP growth has exceeded unemployment for the first time in this recovery, points out Paulsen.
• Next, consider the message from a new measure of inflation used by the New York Federal Reserve called the Underlying Inflation Gauge (UIG). It uses a wider range of data to measure consumer inflation.
The UIG has done a good job of forecasting core inflation. It currently suggests the core consumer price index will hit 2.6% by year-end, and 3% by mid-2019. That would be its highest rate since 1996, and it would surely spook the stock market. More signs over the next few months that we are on this path could weaken stocks. Additional import tariffs imposed by President Donald Trump won’t help, since they raise prices for U.S. consumers.
Here’s a trigger warning to watch for. Signs of inflation will motivate investors to sell bonds, which increases their yield. Once yields back up enough, it starts to hurt stocks. Analysts debate the magic number where damage starts to occur. But many put it at a yield of 3% to 3.3% for the 10-year Treasury note. That yield crossed over 3% on Wednesday.
A saving grace here may be rising capital spending at companies. Managers are a lot more confident with Trump in office. That means they should start spending more. We’re still waiting. But it would be a good thing because capital spending can boost productivity. This effectively makes labor relatively cheaper and offsets the need to raise prices.
6. Trade-war uncertainty
Protectionism, trade wars and tariffs ultimately hurt growth. That’s why it’s best to avoid them. Economic historians blame trade wars for prolonging the Great Depression during the 1930s.
Investors know all this, which is why stocks fall whenever Trump’s saber rattling on trade picks up. And here we go again. On Aug. 1, the White House said it would consider more than doubling its proposed tariffs on $200 billion of Chinese goods to 25%.
“We think the prospects for an all-out, 1930s-style trade war remain low,” says Bob Doll, the chief equity strategist at Nuveen Asset Management.
He’s probably right. But it might not matter, near-term. By now, we know that Trump’s negotiating tactic is to use threats to create fear and uncertainty to soften up the other side. Then he backs off the threats to make a deal. So even if the outcome on tariffs will be benign, as Doll predicts, the fear and uncertainty phase in the meantime will still hurt stocks.
7. A Trump in a China shop
Ultimately, recessions end bull markets. Trump’s tax cuts and fiscal stimulus seem to stave off this outcome, since they contributed to big economic growth in the second quarter. But that’s the wrong way to look at it. The Trump stimulus is probably too much of a good thing.
“History shows that when so much stimulus is added to a reasonably healthy economy, a recession ensues,” says Mark Zandi, the chief economist of Moody’s Analytics. He thinks a recession might happen in 2020. That seems like a long way off. But if more investors wise up to the risks inherent in the Trump tax cuts and fiscal stimulus, it could weigh on stocks by keeping buyers on the sidelines.
Trump’s campaign prediction that we’d all complain at some point about “too much winning” may turn out to be right — because it’s not going to be a good thing if recession is the consequence of all that winning.
