Will there be a SANTA RALLY

The Stock Trader’s Almanac explored why end-of-year trading has a directional tendency. The so-called Santa Claus indicator is pretty simple. It looks at market performance over a “7” day trading period the last five trading days of the current trading year “2020” and the first two trading days of the New Year, “2021”. These trends and stats are compelling. The stock market has risen 1.3% on average during the 7 trading days in question since both 1950 and 1969. Over the 7-trading days in question, stock prices have historically risen 76% of the time, which is far more than the average performance.

 So. should we chase and follow Rudolph’s red nose given the high probability of higher prices by year-end as under performing fund managers “window dress” portfolios for annual performance reports? As noted in there is a 76%-win ratio for the SPX-500 between the 15^th of December and the first week of January and an 24% chance it will not...still the longer-term market dynamics are supportive of a rally into January, So, why am I overly concerned about a “Santa Rally” normally I would not be so concerned if the markets had not already rallied into more extreme levels. (The weekly chart of the SPX-500 index is pushing into more and more extreme overbought conditions now but can certainly get more extreme.) The monthly chart of the S&P 500 index shows more clearly just how stretched markets are getting. While none of these indicators by themselves indicated that the market will correct tomorrow, next week, or even next month, it does suggest investors have harvested most of the “low hanging” market “profit” fruit. 

Interestingly Analysts on Wall Street have been busy upgrading the price targets on their stocks that have reached their 12-month targets within 4-6 weeks. Strategists tend to work from the top-down analysts from the bottom-up. From both directions, I find that Wall Street is extremely, and I mean extremely optimistic. And far too many investors are overly confident that nothing can derail this rally.  What I do know: “momentum” is a “tailwind” for investors. The hope for a real workable “vaccine” that is very-effective allowing the economy to return to normal (like flipping a light switch 😊) with another stimulus package looming is this a reason to be extremely optimistic.

 

12-20-2020  Some thoughts

All my technicals and interpretation of the fundamentals point towards a full-blown mania in the U.S. stock market. The SPX-500 trades near or above record valuations across virtually every metric. Retail traders are speculating in a manner not seen since the massive “Greenspam” fueled Dot-Com bubble. Welcome my friends to the greatest FED show on earth, the newest central-banker great stock market mania of 2020.

Meanwhile, the general investing retail crowd is partying like its 1999 donning massive rose-colored glasses on in both the stock and especially the massively growing option derivative markets. Historically, when these two combinations meet it does not end well for herd-chasing newbie investors.

In today's weekend report, I will dive into each of my premises as to why in greater detail, using both hard data and anecdotal reports. All signs point towards a mania on parity with the Great Dot-Com bubble. That leaves extraordinarily little long-term the upside and significant downside risks in today's overheated stock market. 

Perhaps the most ironclad law of financial markets says that valuation is providence. While valuations cannot tell you what prices will do next month or even next year, they do a good job of providing information for the long-run return expectations for longer-term buy and hold investors.

One of the most reliable valuation metrics for gauging future returns is the CAPE (cyclically adjusted price to earnings) ratio. This ratio compares stock prices against their average earnings over a trailing 10-year timeframe, also it is adjusted for inflation. Historically, the CAPE ratio provides an extremely accurate indicator of future returns:

Thus, when the CAPE ratio is high, you can expect significantly lower future returns over the next 10-year time horizon and vice versa. That is bad news for anyone long the broader market today, given that the SPX-500 CAPE ratio now exceeds the peak reached in 1929 just before the Great Depression ensued.

 

 

But wait, did not I say the most expensive stock market ever and the chart indicates that the Dot-Com Mania was distinctively higher...well, it all depends on which valuation metric you choose. Yes, it is true that the CAPE ratio was briefly higher at the peak of the Dot Com bubble but there is just one problem: what if the definition of real “earnings” changes over time? That's precisely what's happened in recent years, given an massive epidemic of fake engineered (through stock buybacks)!  As far-far-too many firms are addicted to making creative accounting modifications that increase operating profits known as EBITDA (due to self-serving greedy CEO’s and CFO’s) and investors are again turning a blind eye...as I have repeatedly pontificated about

In months/years past a growing proportion of reported profits have been blatantly engineered and manufactured by adjusting away very real costs of doing business and using stock buybacks fueled by debt. We saw a similar ploy in the final years of the Dot-Com bubble, in the form of earnings restatements (I use to cringe when I saw such). As the herd of locoweed feeding investors were led to believe in the 1998 into 2000 period that profits were rising, but when future revisions were considered, they had in fact been lackluster at best or falling.

 

One way to avoid falling prey to such a trap involves simply valuing stocks on sales instead of earnings. The reasoning is of course logical and straight-forward: it is much more difficult to massage revenues than it is for earnings (trust me). Using the basic price to sales ratio, the SPX-500 today trades at its richest valuation ever - even exceeding the Great Dot-Com bubble peak!

The CNBC hyping bullish cheerleaders argue that the market is a forward-looking mechanism, and the data points presented so far are all backward and present conditions looking.

So, let us consider the forward earnings outlook. Coming into this year, the FactSet consensus analyst estimate pegged 2021 SPX-500 profits at $196.70. Today, the same analysts forecast 2021 earnings of just $169.20, per the latest FactSet data. 

Meanwhile, the S&P 500 is up more than 10% YTD despite the forward earnings outlook dropping by 14%. If the market were rationally pricing in future earnings at a constant multiple, you would expect prices to be roughly 25-30% lower. And even then, we would still be at the high end of the historical valuation spectrum. Of course, I have talked about lofty valuations as a reason for caution since at least 2018... and yet, the market continues marching ever higher. But the key difference between 2020 and the past few years of stretched valuations is the sea change in market sentiment and overall speculative fervor has become rampant

For the prior several years, the market has been missing one key element needed to mark a potential euphoric top: the “cabbie” indicator. You know it is time to sell when cabbies give you stock tips that cannot lose and are perceived to only rise into the stratosphere (when this happens this bull market is over). As market manias do not die due to massive over valuation; they only die when speculators can no longer find another willing bag holder “greater-fool” to buy at ever higher prices. When every marginal speculator has ventured into the shark-infested pool and is basically fully committed to this one directional FED manipulative market. When you can no longer walk down the street without getting a stock tip, it is an obvious sign that the supply of new locoweed infested / induced herd of speculators is running extremely low as everyone is already in the game (believing no one can lose).

Remember that it was common knowledge that stocks were grossly overvalued for several years before the peak of the Dot-Com bubble in March of 2000 (I issued my world class SHORT / SELL alert [I was early by 3+ months the day after Thanksgiving of 1999) even Fed-head Greenspam famously called out the stock market's “irrational exuberance” in 1996...but we were not constantly hearing about our so called neighbors or their kids getting rich on the latest Dot-Com IPO, or your co-workers quitting their jobs to become day traders....fast forward to 1999, and all of these things were now happening.  I remember reading a TIME article referencing that Barton Biggs, an analyst at Morgan Stanley Dean Witter, confirming wherein he laments the story he sent to clients about his plumber, who is so busy trading he will not come to his house to fix a leaking pipe. He also spoke about the guy “cabbie” leafing through Barron's for that day's stock trade. It was an epidemic, which was extremely alarming to me. And as I have mentioned that was the “cabbie” indicator I often relief upon flashing bright RED in 1999, and that is exactly what is been missing from the current bull market monster rally until now.

But before you can fully appreciate the speculative fervor I am speaking about here as we close out 2020, it helps to first step back and consider the massive driving forces that are propelling the markets here. And once again, we can draw lessons from the Greenspam massive liquidity pumping into Y-2-K that fueled the Dot-Com era.

Also remember before the internet, trading stocks meant physically calling your stockbroker and paying hundreds of dollars for each transaction. If you wanted livestock quotes, you had to pay thousands of dollars, or call up your broker to manually check prices one stock at a time. These barriers effectively prevented an entire class of Americans from speculating in the market. But everything changed with the rise of the “Al Gore” internet in the 1990s. For the first time, the vast majority of average Americans could monitor their favorite stocks and trade instantly with the click of a button. Online trading also helped as they dramatically reduced overall brokerage commissions from around $70 per trade in the early 1990s down to around $14.99 by 1999 so my slippage dropped considerable. The combination of vast lower transaction costs and greater ease of access unleashed a record “speculative” boom in retail participation in the markets by “cabbies, stay-at-home-moms, and others”. By 1999, almost 10.5 million Americans were now trading stocks online. These new retail traders and the FED provided the critical fuel for inflating the Dot-Com bubble, and of course, we all know how that story ended...

 

Now fast forward to 2013, a mere 4-years after the great TBTF banker led Great-Recession a new hyped incessantly new bull market was emerging just as the Millennial generation began entering the workforce. We saw that significant progress was made lowering trading fees, but investors were still paying $4.99 to $9.99 per transaction. Then a market disruption came in April of 2013, when a service called Robinhood launched its zero-commission mobile trading platform, with no minimum deposits required (they just allowed others who paid a fee to see order flow and step in ahead of their clients) Interestingly Robinhood also offered the unique ability to instantly trade even as deposited funds were supposedly being processed. So a psychological instant gratification system was built into the platform, including the highly gamified trading interface, which many describe as addictive and encouraging of speculative behavior (how could that happen by chance 😊) within a mere five years, Robinhood had amassed over 3 million users, or roughly the size of E-trade. This parabolic rise forced a competitive industry into making a simple choice: follow Robinhood's lead, or risk losing even more market share. The industry relented in October 2019, when Schwab matched Robinhood's zero commission fee structure and within mere weeks, Fidelity, TD Ameritrade and E-Trade all followed Schwab’s lead. Then bang almost overnight, free stock trading went from a niche product to industry standard.

The result: by late 2019, practically all remaining cost barriers to stock market speculation had been erased. For the first time ever, anyone with a few dollars and a smartphone could download an app and begin instantly trading stocks, options, and even cryptocurrencies. And they believed it to be child’s play. That was some of the fuel along with the FED’s free-flowing liquidity that sat waiting for a spark... and it was a short wait for the spark...as when King-Trumps and the various governors started their lockdowns in response to the Covid-19 pandemic which started in March 2020, millions of newly unemployed Americans found themselves without a job, an government $1,200 stimulus check and extremely generous unemployment benefits ($600 a week over and above state benefits) and few if any solid options for leaving the house and to be in potentially harm’s way of Covid-19. As far too many found themselves out of a job without benefits, and extremely limited options for replacing that lost income. And the government was handing out bailout checks to any firm that wanted one whether they needed it or not, and the FED was backstopping reckless debt issuance... It was the perfect force 5-hurricane storm that unleashed a record flood of new money, and importantly retail money into the stock markets and it was aided by the hyping financial media who projected Dow 50,000 and Nasdog 40,000 and the SPX-500 should rise to 6,000 and I am not just talking about a Robinhood phenomenon. Every major brokerage firm reported record new account openings in the first quarter of 2020:

Basically, the Covid-19 pandemic produced the “cabbie” moment that transformed a bull market into an outright raging incessant mania.

 

I am quite certain that the recent boom in retail trading has been turbocharged by the elimination of retail commissions. Interesting that for far too many Americans the stock market has become an economic lifeline for replacing lost income during the Covid-19 pandemic. It is not just the younger generations catching day trade fever. A Wall Street Journal reporter recently described how the pandemic turned her parents into day traders:

During my four years writing about financial markets for The Wall Street Journal, my parents and I almost never discussed stock trading... When I returned to Iowa to visit them in August, it was all they wanted to talk about. I hope that you get the picture. For the first time in this very long in the tooth long bull market, the “cabbie” indicator is flashing red. We are now at that point in my opinion in this highly manipulated bull market when novice investors are aggressively speculating in some of the market's riskiest plays; and for the most part they are playing a game that's unwinnable as they speculate on short-term stock price movements. Sure, some will succeed but 90% of those who try will fail. Unless it's different this time, when any amateur can suddenly become a “master” successful day trader overnight, it's almost certainly an indicator of a massive type of mania. If only 10% of day traders succeed in the stock market, you can probably cut that number in half to 5% in the options market the deep end of the riskiest cesspool pool, where retail traders have recently piled into in mass. Once upon a time the options market was originally designed to provide institutional investors the opportunity to hedge portfolio risk. It also provides the opportunity for speculators to make leveraged bets on stock prices. However, the odds are heavily stacked against the options speculator, for many reasons as the speculative option buyer is always fighting both time and the spread between the underlying stock price and the option strike price. But during a mania, the pay-off in call options can be huge as we have seen of late. So do to the GREED emotion we have seen that this upside potential has attracted the same speculative fervor among retail traders that we are seeing in the stock market. In many ways, this record call buying activity adds more fuel to the melt-up in the underlying stock market.

 

My premise is simple: it is not different this time. When the price momentum ultimately reverses, and it will... there is major downside risks 30-50% in today's stock market. I advise that you all exercise extreme caution is advised.

 

This weekend 12-20-2020 I wrote this...

Traders & Investors especially the CNBC cheerleaders are hyper-bullish as we run into the holidays...and of course I am raising many concerns over a massive jump in investor sentiment (seems very illogical).

In this euphoric and giddy markets stock valuations and real corporate earnings growth no longer appear to matter.   Nvidia is up more than 170% over the last 9-months.  Perhaps we will see similar gains from here.

For 2021 which is what the street seems believes with their price targets; of course, there is nothing like an epic FED induced and engineered stock market bubble that would otherwise be impossible without their incessant manipulation and intervention.  

On the back of the premise that historic low-interest rates simply justify high nosebleed market valuations. 

Another premise is that the FED can permanently inflate stocks using their seemingly unlimited supply of credit.

These premises are nearing their proverbial expiration date.  Investors that are counting on there always being a greater fool will discover what happens when you overpay for a stream of future cash flows that will not unfortunately exist.  At critical stages in the stock market “like now” your long-term success in this environment often comes down to what you do not do, as opposed to what you do.  Above all, you want to avoid doing something stupid like blindly following the herd of investors off a proverbial cliff.  Something that will set you back a decade or more in your goals of accumulating long-term wealth.

 The market is at a critical stage as after peaking at 3,386 on February 19^th (before the official Covid-19 pandemic started) thereafter SPX-500 abruptly loss over 34%, reaching an interim bottom in 2020 of 2,237 on March 23^rd since then, as of Thursday’s close (December 17^th) at 3,722.48 (an all-time closing high, over 1,485 points higher than it was in February before the Covid-19 started), the SPX-500 is up over 66%.  In addition to the SPX-500, the Dow and the Nasdog have also attained new record closing highs, utterly amazing during this dismal economic period!

 CNBC and other financial cheerleading financial networks are touting a resumption of a mega bull-market and are enticing many to buy stocks.  But remember, investing psychology goes contrary to most other purchases you will make in life.  While most folks can quickly discern a bargain price for a pair of shoes or a TV, with stocks, they have the uncanny ability (94% of the new-bull herd) to buy high and sell low.  Fear and greed emotions seem to always get in the way of rational thought and decisions.

 Just perhaps, as the economy starts to re-open back up, growth will come roaring back in mass like flipping a proverbial light switch.  Maybe the new Covid-19 vaccine(s) will soon make this all malaise and contagions just a terrible bad dream and seeing these possibilities would not now be a great time to buy stocks (😊)? This rose-colored glass scenario appears to be what many are banking on.  They continue to push stocks higher with every positive report of a vaccine rollout or a new stimulus bailout potential bill emanating from the lamebrains in our Congress. **Maybe they are right (but I do not think so!) ** Please remember my recent warnings as this is an extremely dangerous stock market.  There are plenty of nasty unknowns (mostly negatives) with respect to the economy and markets.

Ø  How much economic damage did the previous King-Trump and Governor’s lockdowns do, and what will the new targeted lockdowns do? 

Ø  How long will it take for the real economy to recover? 

Ø  What are the implications for the massive and I mean massive deficit spending and monetary stimulus measures that have been so rampant result in? 

Ø  When will this equity and the “general asset” bubble finally pop?

I know that I have been screaming the “bubble” is expanding to near popping size for several months now and have been wrong due to headlines about the vaccine and stimulus, as I have warned that the U.S. stock market’s rebound amid the Covid-19 pandemic is a bubble that will end up imploding and disseminating many investors. In the months since I warned (September 2020) the equity market, the bubble has continued to inflate and inflate as it stretched to new historic highs. 

 This is the 3^rd market bubble that I believe I have accurately predicted (Dot.com, Housing, and now the Covid-19).  My basic market premise and philosophy is very pragmatic.  It is centered on a commonly used phrase “reversion to the mean”.  This is a premise that all asset classes and markets will revert to mean historical levels from highs and lows. Reversion to the mean, as an investment philosophy, is the recognition that financial asset prices in relation to their underlying value will get out of whack from time to time (bubbles and cesspools).  The greed and euphoria of a bull market almost always significantly overshoot into a dangerous Hindenburg size bubble...similarly, during a fear driven bear market and mass liquidation, financial asset prices fall to a massive significant discount to their underlying value. Logic states that the time to buy is when prices are vastly discounted.  So, too, the time to sell is when prices are high. 

Massive Fed-induced bubbles often inflate much further and grow much more extreme than a rational logical observer would and could expect.  In a world gone mad afloat with central-banker liquidity, the divergence can grow wider and more extreme before the reversion starts.