What You Need to Know Before Buying (and Selling) Stocks Right Now

The S&P 500 has gone 267 days without a correction of 5% or more. (Hat tip to my fellow Edelson Institute colleague Dave Dutkewych for bringing this to my attention.) That’s its longest winning streak in 20 years.

But this bull market is badly in need of a correction. And a 5% correction may be the best-case scenario for the U.S. averages.

You have to admit: The U.S. economy is touch-and-go. President Trump’s economic agenda is a hope and a prayer at best. And many worry the Federal Reserve is about to trigger a recession if they keep raising interest rates and begin to unwind their balance sheet.

But perhaps the biggest threat to equities right now … is equities themselves.

Return on equity is a measure of the profit that companies make on money invested by shareholders. And ROE is at its lowest since World War II.

Plus, the CBOE Volatility Index (VIX) remains gruelingly low. Same with corporate bond spreads. Each measure suggests investors are complacent about risk.

In addition, share buybacks — the saving grace for share prices when earnings were contracting — decreased 17.5% from a year ago. Either companies don’t feel the need to rescue their share prices anymore, or they are worried about buying at these levels.

Finally, equity market valuations are a concern …

A price-to-earnings ratio (P/E) near 22 is in the top 20% of historical P/E measures. And the Cyclically Adjusted Price-to-Earnings ratio (CAPE) compares stock prices with corporate earnings over the past 10 years.

For U.S. stocks, CAPE stands at 28. This is a level that typically precedes significant market declines and longer-term underperformance.


To say stocks are due for a correction is an understatement of this eight-year bull market.

Sure, there are things the bulls can cite to rationalize higher equity prices. First-quarter earnings season was good, and second-quarter earnings have beaten estimates more than 75% of the time thus far.

Bulls might also point out that cash is plentiful …

According to a measure of M2 global money supply used by JPMorgan, there is $5 trillion of capital sitting on the sidelines waiting to buy stocks.

Add in the common perception that equities are the only game in town, and the prevailing wisdom remains “buy the dip.”

But, for the last 18 months, I’ve been watching a pattern unfold on the S&P 500 …


That 5-wave pattern on the S&P 500 very closely resembles a long-term Dow Jones Industrials bull market from 1932 to 1987. We’re within spitting distance of a critical resistance level — roughly 2,500 — that I identified early last year.

And we’re at a place in the pattern that corresponds with the Dow Industrials’ 16% decline in 1983. Once the dust settled, however, the Dow surged substantially higher until the market collapsed on Black Monday.

This time, when a correction arrives, major averages could fall 5%, 10% or even 16%. That’s why you should protect yourself.

Stop-loss orders are a good idea. And aggressive traders might consider shorting the market by purchasing put options on something like the SPDR S&P 500 ETF (SPY) or the SPDR Dow Jones Industrial Average ETF (DIA).

If options aren’t your thing, you might seek out and buy shares of an inverse ETF such as the ProShares Short S&P 500 ETF (SH).

Do right,
JR Crooks

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Comments 7

  1. Jim July 21, 2017

    Ok I’m part of the 5 trillion. But current taxes and inflation go on everyday.
    How long can I and my brethren wait to start earning something to replace the principal decline?

    Reply

  2. Wayne Baseley July 21, 2017

    Knowledge is POWER

    Reply

  3. Antoaneta Pinto July 21, 2017

    Scary.

    Reply

  4. Susan July 22, 2017

    Any other advice besides shorting? Should we be selling stocks that have made a substantial profit? Some of mine have made 48%. Should I cash in then bottom feed on good quality stocks when the market tanks ? I would appreciate some solid advice, I have researched extensively on the subject but can find nothing conclusive.

    Many thanks.

    Reply

  5. ralph johnson July 22, 2017

    i find it curious that you look at this 5 wave chart and somehow want us to believe it is a precursor to a future fall (or rise) ……..the durations are way different and while you might have “squeezed’ a correlated look-a-like to some degree, this remains to be seen as a true predictor or harbinger…..although, of course, you do have a 50/50 chance of being sorta right …….or sorta wrong, no?
    past is/may not be prologue–given the completely (now) irrelevant metrics of individual stocks of a company w/r/t the crazy, variable “reporting” of required SEC reports…..with their spectrum of weird, if not phony, numbers ranging from old-school GAAP (rare…these days…) to super creative pro-forma mechaniztions that often show to be fantasy…… and hard to believe any agency could sanction-let alone rely on as a measure of performance….

    Reply

  6. Chris Johenning July 22, 2017

    Curious how the High market PE correlates to bond interest rates. I have to feel a higher PE is acceptable with the current alternative options.

    Reply

  7. Rick Lorusso July 26, 2017

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