Written by Jim Welsh
Another Shoe About to Drop
In the May 4 WTR I noted that although valuation may be a poor timing tool, ignoring valuations can also be a mistake:
“Valuation is a very poor timing tool, but there are times, like now, when ignoring what investors are expecting could be a big mistake.”
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Last week a number of well known investors who are highly respected due to their investment track records over a period of decades weighed in on the valuation of the market. On May 12, in a speech at the Economic Club of New York, Stanley Druckenmiller told the audience that:
“The risk-reward for equity is maybe as bad as I’ve seen it in my career. I don’t see why anybody would change their behavior because there’s a viral drug out there.”
This was a reference to Gilead Science’s drug “remdesivir”. He did concede that one of the wild cards was the Fed:
“The wild card here is the Fed can always step up their (asset) purchases.”
On May 13 Appaloosa Management founder David Tepper said in a CNBC interview that the market maybe the second-most overvalued stock market he’d ever seen:
“I would say ’99 was more overvalued.”
He also said some Big Tech stocks like Amazon, Facebook and Alphabet may be “fully valued“:
“Just because Amazon is perfectly positioned doesn’t mean it’s not fully valued. Google or Facebook are advertising companies. They are not rich but they may be fully valued.”
Scott Minerd, Guggenheim’s Chief Investment Officer, said on Twitter that the stock market had reached the top of its rally and:
“now we find out if this is 1930 all over again.”
The last time the S&P 500’s Forward P/E was 23 was in the late 1998 through 2000 which was during the Dot.com bubble level of valuation. The difference and one would think it is an important difference, is that the economy was in pretty good shape going into 2000. In 2020 GDP is projected to contract by more than -6.0%. It is not uncommon for the forward P/E to rise as GDP slumps and earnings decline, since the E of the P/E is falling.
However, psychology is over riding the carnage that is happening on Main Street, as institutional investors are mesmerized by the actions taken by the Federal Reserve and the potential of another $3 trillion being thrown at the economy by Congress. This is powerful stuff. The mentality it has created will lead investors to find comfort when restaurants are operating at 60% of capacity and the airlines are flying 70% of their fleets and at 65% of capacity. Few firms will be able to make money, but in the short run few are focusing on this longer term outcome.
Today’s spike higher was driven by news that biotech firm Moderna has a Phase 1 trial of 45 patients ages 18-55, and reported that 8 of those patients are doing well. This is good news. Heck any news that suggests that a vaccine to treat COVID-19 may become a reality is good news.
There are a couple of issues.
As discussed in the May 11 WTR:
“COVID-19 is more deadly and far worse for those over the age of 55 when compared to those under the age of 45. It is especially bad for people who are older than 65. Spending by consumers 65 and older represents just over 20% of GDP, with those older than 55 contributing more than 40% of GDP.”
Sooner or later Moderna and every other biotech firm working on a COVID-19 vaccine will have to conduct a trial that includes those over 55 to prove that it is effective and doesn’t have significant side effects that preclude it use for those most vulnerable to COVID-19. Without a vaccine that can be given to those over 55 safely, the drag from less spending by those over 55 will keep the rebound in GDP growth muted.
The Swine Flu in 2009 (H1N1 Pandemic) was a coronavirus and it was seasonally sensitive. The number of Swine Flu cases fell by more than 50% after peaking in mid June in 2009 through the end of August.
This suggests that COVID-19 may experience a seasonal drop during the summer as well. After the low in H1N1 cases in late August however, Swine Flu cases quintupled by November 2009, before collapsing in December 2009. The CDC estimates that 12,469 people died from the Swine Flu and the WHO estimates that 0.001% to 0.007% of the world’s population died.
The Swine flu pandemic primarily affected children and young adults, and 80% of the deaths were in people younger than 65. That was unusual, considering that most strains of flu viruses cause the highest percentage of deaths in people ages 65 and older. In the case of the Swine flu, older people may have already built up enough immunity to the group of viruses that H1N1 belongs to, so they weren’t affected as much.
If COVID-19 follows the path of the Swine flu and a second wave of infection materializes in the fall, Moderna’s vaccine will not be available in time to address it, which suggests the stock market’s enthusiasm on the news may prove premature and excessive.
As of May 15, 48 states were opening their economies after varying degrees of being shutdown. Based on the images during the weekend of May 16-17 of crowded bars, restaurants, markets, malls, and beaches with the majority of people not wearing masks, one can reasonably expect that an increase in infections is coming in the next few weeks. This increase could be magnified as many more people enjoy the upcoming Memorial Day weekend with parties.
The Gallup Poll was taken on April 14 -20 and found that less than 30% of those polled thought wearing a mask was effective. This percentage may have increased since the poll was taken, but the adherence of wearing a mask is not likely above 60%, and that appeared to be the case last weekend. This suggests that an increase in infections is coming by mid June that could result in some cities choosing to reinstate shutdowns or close certain types of businesses i.e., bars and restaurants.
The media has indulged in showing any failing in the handling of COVID-19, with most of the criticism warranted. The emphasis though has been decidedly one sided against whether the economy should be reopened and the media will lavish much attention on any increase in infections as proof the economy shouldn’t have been opened. This could make any new increase seem larger than it truly is, but it will also attract more viewers and may contribute to a decline in the stock market during the first half of June.
Stocks
The stock market’s rally on May 18 was quite strong with 2647 stocks rising and just 332 falling, a ratio of almost 8 to 1. It was also of interest that the Mega Cap stocks actually lagged when compared to the broader market. The Nasdaq 100 was up 1.86% and the S&P 500 jumped 3.15%, while the New York Composite gained 4.16%, the Equal Weight S&P 500 was up 5.47%, and the Russell 2000 soared 6.1%.
So for this one day the unloved and beaten down sectors received a big boost as investors hope that a vaccine from Moderna will lead to a recovery that begins sooner and is stronger, especially in 2021. It wouldn’t be a surprise if some analysts are so moved that they will increase their S&P 500 earnings estimate for 2021!
Despite this one wonder day boost the broad market averages failed to exceed their late April high even as the Nasdaq 100 and S&P 500 did. It will be important to see to this one day phenomenon is able to carry forward. It would be negative if the market reverses lower before the broad market averages exceed their late April highs.
It is remarkable that despite the magnitude of the rally since the March low, the percent of stocks above their 200 day average was just 13% on May 15. (Chart below) The rally on May 18 only lifted the percent to 17%, and comfortably under 20%. When one compares how quickly the percent rose above 20% in early January 2018, it illustrates that the majority of stocks have been lagging badly behind the S&P 500 since the March low. The Mega Cap stocks comprise 21% of the S&P 500.
The NYSE Advance – Decline Line is also below its late April high even though breadth was strong today.
The 21 day Advances minus Declines moving average registered a lower high even though breadth was strong and the S&P 500 exceeded its April 29 high.
Sentiment became a bit excessive last week with the Call/Put ratio reaching a level (red horizontal line) that has coincided with at least a short term high in the market. The exception of course was the extreme reading registered in January and February as the market was in the process of topping. The expectation is that the Call/Put ratio will fall to near 1.0 (green horizontal line) before the next sustainable rally begins.
The stock market is expected to decline if the reopening of the economy results in an increase in COVID infections in coming weeks. The S&P 500 is expected to at least test the intra-day low of 2767 while the Russell 2000 drops below its May 14 low.
Last week I recommended establishing a 25% short position in the Russell 2000 at the opening on May 12 through the purchase of the inverse ETF. RWM opened at $40.34 and on May 14 I sent a Special Update advising the sale of half of the position. When the email was sent RWM was trading at $44.67 and subsequently traded as high as $45.32. For now use $39.10 as a stop on the remaining half. Four weeks ago a 25% short position in the S&P 500 was recommended at 2880. For now use a stop of 2995.
Treasury Bonds
Despite the bullish Moderna news and hope that the economy will be doing much better in 2021, the 10-year Treasury remains below 0.85%, which was the expectation. If infections increase as the economy is reopened and the stock market reverses lower, the 10-year Treasury yield has been expected to eventually fall to the near the lows of March 9 (0.398%). Until that happens Treasury yields are likely to chop sideways.
30-year Treasury Yield
The 30-year Treasury yield has been more bouyant than the 10-year, which bears watching if the relative weakness persists. The 30-year is testing the trend line connecting the two most recent high in yields. Should it close above the black trend it will reinforce the relative weakness in the long Treasury market. For now, the 30-year yield is likely to fall under 1.126% and possibly approach the March low of 0.837% if the S&P 500 drops to 2700.
Gold
The analysis last week proved prescient:
“Since peaking at $1744 on April 14 Gold has been forming a triangle which leaves open the possibility that Gold could briefly spike higher and above $1744.”
During overnight trading on May 17 Gold spiked up to $1764 before reversing lower. This type of spike and reversal lower confirms the triangle formation. Gold is likely to drop back to the low of the triangle at $1664 at a minimum.
Silver
In the May 11 WTR I suggested Traders short SLV as long as it was above $14.30 using $14.64 as a stop. On May 12 SLV opened at $14.58 and the stop at $14.64 was trigger on May 14. The stop was well placed as SLV spiked higher after Gold broke out of its triangle to the upside. SLV left two gaps during the spike that are likely to be filled in coming weeks.
This spike likely eliminates the potential of SLV retesting its March low, and may indicate that Silver is about to end its relative underperformance to Gold.
Gold Stocks
The Gold stocks rallied after Gold broke out, but GDX’s RSI still looks like it is rolling over. If the spike higher in Gold completes the latest leg higher and is followed by a drop to at least $1664, the Gold stocks are going to correct. The correction could be deeper than expected if the stock market suffers a correction in June as is the expectation. A decline to $29.75 is the minimal expectation and with the potential GDX could trade under $27.00. GDX’s RSI is expected to drop at least below 40 which will be one of the first signs of an impending trading low.
Dollar
The sideways chop can continue as long as the Dollar doesn’t close below 98.75 (horizontal trend line) or close above 101.00. A close above 101.00 would lead to a test of 103.00, which could also pressure the stock market. A close below 98.75 would open the door to a drop to 96.50.
Emerging Market
Since the peak in January 2018 at $51.76 EEM has persistently underperformed the S&P 500, which is why the Relative Strength moving averages have trended lower. EEM’s relative strength hasn’t improved even as EEM rallied off the March 23 low. The black horizontal trend at $37.90 should represent a wall of over head resistance and is expected to contain any further advance.
EEM is expected to trade down to $30.10, which was the intra-day low on March 23. This would complete its Wave 5 decline from the high of 46.32 and Wave (C), and set up a great buying opportunity.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal when it crossed above the red moving average on April 16 when the S&P 500 closed at 2800. A new bull market would not be confirmed unless the MTI is able to get above the green horizontal line. If the past is any guide the BMR may prove to be a whip saw trade as the table below illustrates.
It is common after a large decline that drops the MTI below the red horizontal line (chart below), for the first BMR buy signal to be followed by a retracement that is deep enough to cause the MTI to cross back below the red moving average. In the current environment this outcome seems likely, unless the U.S. is able to reopen without a meaningful increase in infections.
A crossover below the moving average is considered a sell signal. The expectation is that the S&P 500 will decline enough to cause the MTI to fall below the red moving average, even if a full retest of the March 23 low does not develop. Since 1962 the smallest whip saw loss was -4.0%, which would bring the S&P 500 down to 2688. The average whipsaw loss was -7.9% suggesting a drop to 2580. In 1987 there was only a single crossover, but there was also a full retest of the initial low prior to the bear market rally buy signal.
Disclosure
The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.
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