For most of 2019, the stock market has been on a tear. In recent weeks, new records have been set in every major market index. It’s a time of extreme optimism — but should it be?
The stock market often flashes signs of trouble that go totally unnoticed when prices are steadily rising.
Below are five signs of trouble in the stock market, some of which are flashing red. That doesn’t mean it’s time to bail out of stocks, but it may be the very best time to become more cautious.
1. The Inverted Yield Curve
In the normal course of events, longer-term interest rates are lower than shorter-term rates. It all has to do with risk. Since longer-term securities tie up your money for extended periods, investors typically demand higher interest rates than for short-term securities.
An inverted yield curve takes place when the situation reverses. Investors are willing to accept lower returns on longer-term debt securities than on shorter-term ones. A major reason for the inverted yield curve is the expectation by investors that future investment returns will be lower than they are now. Investors flock to safe intermediate-term U.S. Treasury securities to lock in current yields as protection against lower returns in other assets, primarily stocks.
Yet another troubling issue with the inverted yield curve is that one has proceeded each of the last seven recessions, going all the way back to 1956. Recessions are also bad for stocks because they lead to increased unemployment, lower corporate profits and ultimately lower stock prices.
We are currently in an inverted yield curve.
To illustrate the point, below is a screenshot of the U.S. Department of the Treasury’s Daily Treasury Yield Curve Rates for July 23, 2019:
You can see the yield on the one-month Treasury bill is 2.12%. But as you make your way across the row of interest rates, you’ll notice that returns on securities ranging from three months to 10 years are lower than the yield on the one-month bill.
Of particular interest are the yields on the five-year Treasury note, currently at 1.83% and on the 10-year note at 2.08%. The fact that investors are willing to accept lower rates on securities ranging from five to 10 years than they are on a one-month security is highly abnormal and a definite warning sign.
2. Widespread Complacency
This is really about market sentiment or how investors perceive the financial markets. In general, a positive sentiment is consistent with a rising market. A negative sentiment is indicative of a bear market.
There are several factors that can affect sentiment, including political developments, pronouncements by the Federal Reserve and geopolitical conditions. There are also economic indicators. For example, trends in the Consumer Price Index (CPI) may indicate future inflation. That can foretell an increase in interest rates, which is generally bad for stocks.
Rising government deficits can also point toward higher interest rates, since the U.S. government is the largest debtor of all. (See the section below on “The National Debt.”) Conversely, a rising unemployment rate can point toward a weakening economy, which will negatively impact corporate profits and eventually, stock prices.
Any of these can affect market sentiment, but even more so if several are heading in the wrong direction. But at the moment, both economic indicators and political and international events appear stable. And with the Fed signaling potential interest rate cuts, overall market sentiment is very high, which at least partially explains record stock prices.
But since market sentiment is based primarily on emotion, it can shift at any time. Ironically, positive market sentiment itself can be an indication of a market top and darker days in the stock market.
Common Measures of Market Sentiment
Investors and analysts look at several objective measures of market sentiment to determine investor mindset. Individually, none are indicative of a shift in market direction. But two or more can be flashing warning signals that shouldn’t be ignored.
Based on the current readings of the measures below, investors are displaying widespread complacency. That could be a warning sign. Bad things often happen when — and precisely because — no one thinks they can.
Often referred to as the “fear index,” it’s more technically known as the CBOE Volatility Index. It measures options activity to calculate a real-time index of the expected level of price fluctuation in the S&P 500 index over the next year.
When the index is high, it indicates greater uncertainty and a possibility of a significant change in stock prices. When its low, market sentiment is higher, projecting market stability. The volatility index is currently at around 12.3, compared to an average valuation of 19. The low valuation suggests traders expect market stability, which is typically good for stock prices.
When an investor shorts a stock, it’s done in anticipation of a major drop in price. The investor will gain if the stock falls. Short interest is the number of shares that have been sold short but have not been either covered or closed out. It’s expressed as a number or percentage. High short interest indicates pessimism, while low short interest indicates optimistic sentiment.
But in an ironic twist, high short interest can also indicate strong future performance in the market. It indicates extreme pessimism, and stocks are known to “climb the wall of worry”. High short interest means there is a large number of investors in short positions who will need to buy back the shares they short sold if the market climbs, causing prices to rise even more.
The current level of short interest is just about at the middle of the range for the past 10 years, which is a neutral indicator.
This indicator uses the 50-day simple moving average (SMA) and 200-day SMA to measure market sentiment. When the 50-day is higher than the 200-day, it indicates bullish sentiment. But when the 50-day is below the 200-day, it indicates bearish sentiment.
As of July 23, 2019, the 50-day SMA is higher than the 200-day SMA on the Dow Jones Industrial Average, pointing toward continued higher stock prices.
But at the same time, it also confirms widespread complacency.
The High-Low Index
This index compares the number of stocks reaching 52-week highs versus the number hitting their 52-week lows. An index rating below 30 indicates bearish sentiment, while a reading above 70 represents bullish sentiment. (50 is the dividing line.) For most of 2019, there have been more new highs than new lows, indicating positive sentiment.
This could point to higher stock prices ahead. Or it could be another marker of the widespread complacency that proceeds bear markets.
3. Excessive Valuations
The current price-to-earnings (P/E) ratio on the S&P 500 is sitting right around 22. Since the historic average P/E ratio on the S&P 500 is about 15, the current level may indicate the market is overvalued by about 33%.
However, the current level isn’t necessarily pointing to trouble. The trailing P/E on the S&P 500 has been hovering around the 22 mark going all the way back to 2014. That means we’ve sustained a relatively high market P/E ratio for five years without experiencing a major downturn.
In fact, the consistency of the P/E ratio may even be pointing to 22 as the new normal.
Given that interest rates are also currently at historic lows and have been trending in the same general range since 2009, the higher P/E ratio on the market may be less a problem. After all, technically speaking, the P/E ratio on the 10-year U.S. Treasury note is currently sitting at about 48.5 (100 divided by the interest rate yield of 2.06%).
Given the very low yields on intermediate-term U.S. government securities, investors may be much less concerned with the higher than normal P/E ratios on stocks. The potential for continued price appreciation in stocks may outweigh the perceived risks of the higher P/E. And we have five years of higher P/E ratios to support that conclusion.
But That Doesn’t Mean High P/E Ratios Are Signaling “All Is Well”
The market may not ignore high P/E ratios forever. While it may not be an issue in the current market, a triggering event could suddenly cause high P/E ratios to be an underrated risk. It could turn into one of those moments when investors look back and ask, “What were we thinking?”
For example, an unexpected increase in interest rates could change investor sentiment about P/E ratios. Stocks could begin falling, starting with those companies with higher P/E ratios. Once the highflyers begin to sell off, it could start a chain reaction that leads to a bigger than expected decline in stock prices.
That is what happened in the last two stock market crashes. When the dot-com bubble burst in 2000, the major slide in stocks was led by tech companies, then spread to the entire market. Similarly, the crash that attended the 2008 Financial Meltdown was led by financial stocks, starting with companies connected with the mortgage industry. Once again, the crash started in one specific sector, then went marketwide afterward.
Perhaps the moral of the story is that high P/E ratios don’t matter — until they do.
There’s still one more potential sign of trouble related to excess valuations. The four biggest stock market crashes in history — 1929, 1987, 2000 and 2007 — were each preceded by record stock prices. 2019 has produced the highest stock market levels in history.
It’s not that a high stock market in itself is indicative of a declining market. Rather, it’s that crashes begin with record stock prices. When valuations reach record levels, the potential is real that a relatively minor decline in the market could quickly evolve into a major selloff or even another full-blown crash.
4. Declining Credit Quality
The entire U.S. economy runs on credit, including businesses large and small. When credit is expanding, the economy is growing and all is well. But that’s as long as credit performance remains steady. A deterioration in loan performance is a definite sign of trouble for the stock market.
How are we doing with credit performance right now?
- Mortgage delinquencies are at 2.67% through May 2019 and have declined steadily since the peak in 2010.
- Credit card delinquencies have increased slightly to 2.59% after falling to a low of 2.12% in the first quarter of 2015.
- The delinquency rate on installment loans, which include home equity, property improvement, mobile home, auto, recreational vehicle, marine and personal loans, sit at just 1.78%, which is below the prerecession average of 2.09%.
- Commercial and industrial loans have been holding pretty steady just above 1% since 2012.
In looking at current loan performance, there are no signs of trouble for the stock market at this time. Credit performance is continuing to be solid.
5. Irrational Exuberance — Or, Any News Is Good News
Remember earlier when I wrote that a major market decline could be set off by a triggering event? That’s usually the revelation of unexpected bad news, frequently referred to as a black swan event.
But apart from a truly unexpected crisis, there’s plenty of trouble brewing in the economic and global backgrounds. As is typical of bull markets, bad news tends to be ignored — at least until it becomes a recognized crisis.
We have several such situations brewing right now, which the stock market is completely ignoring as it lofts to ever higher valuations. At the moment, each seems to be under control — or investors fully anticipate they will be soon. But a significant and relatively sudden deterioration in any could prick the balloon of euphoria that’s been holding up stock prices.
The Trade War With China
Perhaps because it isn’t a shooting war, the trade war with China is largely being perceived as a benign event. But it represents a heating up of tensions between the world’s two largest economies.
The most likely consequence is that American consumers will pay more for goods manufactured in China, which is pretty close to everything. At the outside, we could come out being the loser in this economic conflict. And at the extreme, trade wars have a history of turning into shooting wars. That won’t be good for anyone, least of which, the stock market.
A Looming Pension Crisis
Public pensions in the United States are underfunded by an estimated $4.4 trillion. Wall Street is ignoring that situation at the moment, because it isn’t having any immediate negative effects.
But public deficits of any kind eventually transform into higher taxes. That won’t be good for the economy, the job market or the stock market.
The Student Loan Debt Problem
Remember all those good-looking (and low) loan default rates under section #4 above? The situation with student loans is dramatically different. 44 million people owe more than $1.5 trillion, and the delinquency rate is 11.4%, defined as 90 days or more late.
That’s an accident waiting to happen, not to mention an albatross around the necks of nearly an entire generation of Americans.
Rising Healthcare Costs
The Balance reported that healthcare spending has increased from 5% of the economy in 1960 to nearly 18% today. That’s a massive and rising drag on the economy. It not only saps consumer resources, but it also lowers company profits. The really bad news is that nothing is being done about it.
The National Debt
The total national debt of the United States is over $22 trillion, which is larger than the entire US economy. And it keeps growing.
The U.S. Federal budget deficit was $160 billion in 2007, and the budget actually had a surplus just six years earlier. The deficit hit a record high of $1.4 trillion at the bottom of the last recession in 2009, and it’s now on track to again exceed $1 trillion for 2019.
What makes this so troubling is that the deficit is expanding so rapidly during a time of prolonged economic growth. Heavy borrowing by the federal government tends to crowd out private sector credit and can ultimately lead to higher interest rates.
Black Swans… or Ignored Problems?
Wall Street has a long and documented history of ignoring structural economic problems until one breaks loose and morphs into an undeniable crisis. Any one of the events described above could be the trigger that pops the stock market’s balloon. In the meantime, none seem to matter — at least for the time being.
The point of this article is to seriously consider the likelihood that the stock market may be in real danger of running on what Alan Greenspan once referred to as irrational exuberance. That’s exactly how every bubble in human history plays out.
But even more important, it’s time to take serious stock in what Warren Buffett once said:
Rule Number 1: Never lose money.
Rule Number 2: Never forget Rule Number 1.
That’s much harder to do when the stock market is trading at record levels. And that’s why a little bit of advanced preparation could go a long way toward preserving your portfolio. This may not be a time to bail out, but it’s certainly an opportunity to take some profits and reduce your exposure.