S&P (SPY) had some of the worst days in its history in the last two weeks. The index has steeply fallen lately and is now 9% off its recent all-time high. In addition, the volatility index or fear index, VIX, has dramatically increased, from 11 to 26, during this period. Therefore, as the investing community has been dominated by fear, the big question is whether the market has peaked and a bear market is in the making.
First of all, whenever the market is in panic mode, it is important to examine where the market stands from a valuation point of view. S&P is currently trading at a trailing P/E=19.7 and a forward P/E=16.8. The forward P/E ratio is above the 5-year average (16.0) and the 10-year average (14.2). Therefore, an additional 5% correction would bring the index in line with its 5-year average. This means that the market does not appear to be so overvalued as to justify the prevailing panic.
Moreover, the ongoing quarter was characterized by the largest increase in the estimates of the earnings per share [EPS] since FactSet began tracking this metric. More precisely, the EPS estimates for the running quarter rose 4.9% last month while the previous record was a 3.5% increase in Q2-2010. The spectacular improvement in the EPS estimates has mostly resulted from the tax bill, the elevated oil prices, which will boost the earnings of the energy sector, and the expectations for higher interest rates, which will benefit the financial sector. Such an improvement in the fundamentals of the market adds fuel to the view that the recent sell-off has little to do with the underlying fundamentals.
The official reason behind the recent correction is the market’s concern that the Fed will raise interest rates even more aggressively in order to fight the rising inflation, which may result from an accelerating economy. However, an accelerating economy should not cause panic to the market. In addition, if the market remains tumultuous for a long while, the Fed will do its best to alleviate its concerns. Consequently, it will not raise interest rates aggressively if the prevailing panic persists for weeks. The Fed will support the stock market, not because the market is its first priority, but because of its impact on the real economy. When the market remains calm, people feel wealthier and more confident on the prospects of the economy. As a result, they tend to spend more and thus provide fuel to the economy. On the other hand, during prolonged panic periods, people tend to lose their confidence and button their wallets. Therefore, the Fed will do its best to support the market, just like it has done for more than a decade.
As the underlying fundamentals do not justify the prevailing panic, the real reasons are mostly technical. To be sure, S&P had rallied 37% since last year’s elections without any correction of at least 5%. In other words, it rallied almost in a straight line, without shaking the confidence of investors, not even once. Consequently, it is the first time after more than a year that investors have a strong motive (fear) to sell and hence there is a congestion of sellers right now. This helps explain the extreme volatility and the dramatic daily moves of the market in the absence of a drastic shift in the fundamentals.
Nevertheless, I have never witnessed a major peak of the market without a few corrections first. More precisely, until recently, the buyers completely dominated the market whereas the sellers were almost absent. That’s why the market went up in a straight line. It is extremely unusual to see the balance between sellers and buyers change completely without an intermediate fight near the peak. That’s why we always witness an attempt of S&P to revisit its peak when it corrects from its all-time high. This is evident in the peaks of 2000 and 2007, as shown in the chart below. All in all, there has been no precedent for S&P to top out without any attempt to retrieve its highs after a correction.
Another factor that indicates that the recent panic has mostly been caused by technical factors is the pronouncedly high leverage of investors. As the chart below shows, the margin debt of investors has climbed to extremely high levels, along with the S&P. Consequently, due to the recent correction, numerous investors have been forced to sell their stocks in order to reduce their risk and regain their sleep at night. Therefore, as part of the recent sell-off has resulted from this forced liquidation, the stock prices have been pressured more than their fundamentals currently dictate.
Finally, the market has a significant tailwind going forward, namely the weakening dollar. As 30% of the sales of the companies of S&P are generated abroad, the strong dollar of the recent years has somewhat hurt the results of these companies. However, the dollar has posted a solid bottom and is likely to remain weak, as some central banks, such as ECB, are about to unwind their QE programs. Therefore, the companies of S&P are likely to enjoy the tailwind of a weak dollar for the foreseeable future.
To sum up, the recent sell-off has mostly been caused by technical factors, such as the extremely high leverage of investors and the absence of a correction for more than a year. In addition, the market has never peaked after a straight-line advance, without a meaningful correction and a subsequent attempt to revisit its peak. Therefore, although the market is fully valued right now, I believe it will at least approach its recent high once again and may even exceed it before the ongoing 9-year bull market ends.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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