3 market warning signs predict 20% stock tumble
Insight: When these indicators flash together, it’s time to sell
By Mark Hulbert, MarketWatch
Shutterstock.com
Over the past 45 years, the stock market has lost more than 20% each time three warning signs flashed simultaneously.
After a selloff this past week dragged the Dow Jones Industrial Average (DJI:DJIA) into negative territory for the year, it’s worth noting that all three are flashing today.
Are stocks due for a 20% slide?
Mark Cook, a veteran investor who called three previous market crashes, believes the U.S. market is in trouble, to the tune of a 20% pullback. He joins MoneyBeat to explain. Photo: Getty Images.
The signals are excessive levels of bullish enthusiasm; significant overvaluation, based on measures like price/earnings ratios; and extreme divergences in the performances of different market sectors.
They have gone off in unison six times since 1970, according to Hayes Martin, president of Market Extremes , an investment consulting firm in New York whose research focus is major market turning points.
Bear in the air
The S&P 500’s (SNC:SPX) average subsequent decline on those earlier occasions was 38%, with the smallest drop at 22%. A bear market is considered a selloff of at least 20%, with bull markets defined as rallies of at least 20%.
In fact, no bear market has occurred without these three signs flashing at the same time. Once they do, the average length of time to the beginning of a decline is about one month, according to Martin.
The first two of these three market indicators — an overabundance of bulls and overvaluation of stocks — have been present for several months. Back in December, for example, the percentage of advisers who described themselves as bullish rose above 60%, a level Investors Intelligence, an investment service, considers “danger territory.” Its latest reading, as of Wednesday, was 56%.
Also beginning late last year, the price/earnings ratio for the Russell 2000 index of smaller-cap stocks, after excluding negative earnings, rose to its highest level since the benchmark was created in 1984 — higher even than at the October 2007 bull-market high or the March 2000 top of the Internet bubble.
Three strikes and you’re out
The third of Martin’s trio of bearish omens emerged just recently, which is why in late July he advised clients to sell stocks and hold cash. That’s when the fraction of stocks participating in the bull market, which already had been slipping, declined markedly.
One measure of this waning participation is the percentage of stocks trading above an average of their prices over the previous four weeks. Among stocks listed on the New York Stock Exchange, this proportion fell from 82% at the beginning of July to just 50% on the day the S&P 500 hit its all-time high.
It was one of “the sharpest breakdowns in market breadth that I’ve ever seen in so short a period of time,” Martin says.
Another sign of diverging market sectors: When the S&P 500 hit its closing high on July 24, it was ahead 1.4% for the month, in contrast to a 3.1% decline for the Russell 2000 (RSU:RUT) .
Expect up to a 20% S&P 500 decline
How big of a decline is likely? Martin’s best guess is a loss of between 13% and 20% for the S&P 500, less than the 38% average decline following past occasions when his triad of unfavorable indicators was present. The reason? He expects the Federal Reserve to quickly “step in to provide extreme liquidity to blunt the decline.”
To be sure, Martin focuses on a small sample, which makes it difficult to draw robust statistical conclusions. But David Aronson, a former finance professor at Baruch College in New York who now runs a website that makes complex statistical tests available to investors, says that this limitation is unavoidable when focusing on past market tops, since “by definition it will involve a small sample.”
He says that he has closely analyzed Martin’s research and takes his forecast of a market drop “very seriously.”
Martin says that expanding his sample isn’t possible because most of his current indicators didn’t exist before the 1970s and “the comparative math gets very unreliable.” But he says he does use several statistical techniques for dealing with small samples that increase his confidence in the conclusions that his research draws.
Russell 2000 could take 30% hit
He says stocks with smaller market capitalizations will be the hardest hit in the decline he is anticipating, in part because they currently are so overvalued. He forecasts that the Russell 2000 will fall by as much as 30%.
Also among the hardest-hit stocks during a decline will be those with the highest “betas” — that is, those with the most pronounced historical tendencies to rise or fall by more than the overall market. Martin singles out semiconductors in particular — and technology stocks generally — as high-beta sectors.
He predicts that blue-chip stocks, particularly those that pay a large dividend, will lose the least in any decline. One exchange-traded fund that invests in such stocks is iShares Select Dividend (NAR:DVY) , which charges annual expenses of 0.40%, or $40 per $10,000 invested.
The average dividend yield of the stocks the fund owns is 3%; that yield is calculated by dividing a company’s annual dividend by its stock price. Though the fund’s yield is higher than the S&P 500’s 2% yield, it nevertheless pursues a defensive strategy. It invests in the highest-dividend-paying blue-chip stocks only after excluding firms whose five-year dividend growth rate is negative, those whose dividends as a percentage of earnings per share exceed 60% and those whose average daily trading volume is less than 200,000 shares.
The consumer-staples sector has also held up relatively well during past declines. The Consumer Staples Select Sector SPDR ETF (NAR:XLP) currently has a dividend yield of 2.5% and an annual expense ratio of 0.16%.
If the broad market’s loss is in the 13%-to-20% range that Martin anticipates, and you have a large amount of unrealized capital gains in your taxable portfolio, you could lose in taxes what you gain by selling to sidestep the decline. But the larger losses he anticipates for smaller-cap stocks could be big enough to justify selling and paying the taxes on your gains.
Stock trader who called three crashes sees 20% collapse
Insight: Veteran investor expects bear market within 12 months
By Michael Sincere
MIAMI (MarketWatch) — Mark Cook, a veteran investor included in Jack Schwager’s best-selling book, “Stock Market Wizards,” and the winner of the 1992 U.S. Investing Championship with a 563% return, believes the U.S. market is in trouble.
The primary indicator that Cook uses is the “Cook Cumulative Tick,” a proprietary measure he created in 1986 that uses the NYSE Tick in conjunction with stock prices. His indicator alerted him to the 1987, 2000, and 2007 crashes. The indicator also helped to identify the beginning of a bull market in the first quarter of April 2009, when the CCT unexpectedly went up, turning Cook into a bull.
What does Cook see now?
“There have been only two instances when the NYSE Tick and stock prices diverged radically, and that was in the first quarter of 2000 and the third quarter of 2007. The third time was April of 2014,” Cook says.
In simple terms, as stock prices have gone higher, the NYSE Tick has moved lower. This divergence is an extremely negative signal, which is why Cook believes the market is losing energy.
In fact, the Tick is showing a bear market, which seems impossible considering how high the market is rising.
“The Tick readings I am seeing (-1100 and -1200) is like an accelerator on the floor that is pressed for an indefinite amount of time,” Cook says. “Eventually the motor will run out of gas. Now, anything that comes out of left field will create a strain on the market.” Since the CCT is a leading indicator, prices have to catch up with the negative Tick readings.
“Think of a dam that has small cracks that are imperceptible to the eye,” he says. “Finally, the dam gives way. Eventually, prices will go south, and the Tick numbers will be horrific.”
Cook is also concerned that the market is acting abnormally. “It’s like being in the Twilight Zone, he says. “Imagine going outside when it’s raining and getting sunburned. That’s the environment we’re in right now.”
Unfortunately, Cook can’t say when this vulnerable market will crack. “The CCT is similar to the new-high, new-low indicator,” he explains. “As the market goes higher, fewer stocks make new highs. Some people might say it’s ‘different this time,’ but it’s never is. Could the market go higher? Yes, it could, but the extension of time will create an even greater divergence that has to be snapped back together.”
Cook predicts that within 12 months, the market will suffer a 20% or greater pullback. Says Cook: “It may take months and months for the correction to develop. I don’t look at how low the market drops, but how it rallies. I will look for lower highs and lower lows. Every rally aborts before the previous high, and every decline penetrates and accelerates below the previous low.”
One of the reasons that Cook has survived as a trader for so long is his credo: “There is always a way to make money.”
For Cook, that means being flexible enough to change strategies and take a 180-degree turn. “The scenarios we will see in the future will be totally different than what is now,” he says. “You will have to navigate differently. It’s like going through a jungle that ends and becomes a desert. There is only one constant, and that is change.”
In fact, Cook excels in volatile markets. “I’m amazed that we have gone over two years without a double-digit correction,” he says. “Without volatility, you get a complacent environment like we have now, which can lead to devastation. You can’t stay at these complacent levels forever. When there is a correction, it will be very severe.”
Cook says that when volatility gets light (like it is now), traders and investors give up. “A lack of volatility is not good for the market,” he says. “Low volatility begets thinness, and that begets low volume, which equals greater risk.” One day, he adds, volatility will return, and so will the traders.
Another key to Cook’s success is his ability to correctly assess probabilities. Right now, he sees a greater than 75% probability of a major correction, but this could unfold over a long period. Says Cook: “The probability of us going up 5% from here is possible, but there’s a higher probability of us going down 20%.”
Cook also is not a big fan of the Fed’s policies. “The Fed is creating abnormalities which creates stress on the markets, similar to a pendulum swinging. I believe the honeymoon is over for Yellen from this point forward. The magnifying glass will be on her. Typically, within 12 months of a new Fed chairperson, the market gets more volatile.”
Cook knows there will be a catalyst that will “burst a hole in the ship, which is already taking on water, even though stock prices haven’t reflected that. The cannonball that will finally sink it will come from a source that we can’t see. But when the cannonball hits a ship that is already partially flooded, it will sink a lot quicker. I’m not sure the Fed is quick enough or flexible enough to head off a disaster.”
Looking forward, Cook says he wants to see if the S&P 500 is (SNC:SPX) lower in July after the backdrop of a better economy, low interest rates, positive earnings, and a lower unemployment rate. If July is down, that would confirm the significant divergence.
“The tape looks exceptionally tired and heavy,” Cook says. “I see a huge divergence between the weak internals of the Tick and the rising stock prices. The divergence is as wide as the Grand Canyon. It’s incredible.”
http://www.youtube.com/watch?v=lW0YGC68qP4
Those two song titles together on that that Beach Boys singles cover just ain’t right!
20% would still leave stocks overvalued. How about 70%?
20% my ass. Like snow on a metal roof, when she goes don’t be there.
final months of the presidency, no reelection to worry about. no need to prime the pump. in the last month or so we will see a crisis unfold, nothing like a good crisis to justify another tarp.
new trend here, instead of pardoning criminals, the outgoing president gives them multi-billion dollar bonuses.
Most people (especially those who are, for some reason, still clutching at middle class) look at “bull” or “bear” markets – expecting them to go up forever or crash in in a heap. Not going to happen.
Markets are controlled so that they either go up or down – a 200 point down day just makes money for those who already know that the market is going to be driven down that particular day. Same way with a rally. Goldman Sachs calls BOA and says “What do you think? Have we driven the market down enough to profit sufficiently if we run a rally tomorrow?” Whatever they decide, the lesser players are informed and sure enough, the market rallies the next day. So much for doing away with Glass-Stegall which let the banks into the markets to coordinate action which, in turn, guarantees profit from coordinated actions. Puke..
Glass-Stegall must be reinstated. Period. TBTF banks must be broken up. Period. Jamie Dimon needs to be castrated – in public. At least tossed in the clink for 100 years.
Since none of the “musts” or “needs” will happen, we will continue with business as usual (ie. status quo) until it no longer works. Some time ‘twixt now and then, but it will be really fast when it happens.
I hope not to be here when it happens – but the way it’s going, I may be unfortunately long lived enough to see is crack and come to pieces. Things seem to be speeding up – or maybe I’m slowing down which makes everything else speed up!!
MA
Muckabout-
I sincerely hope that you make it long enough to see the fun part of the crackup. Seeing shit start to rapidly collapse is going to be a rush.
Along those lines, Muck – do you have iron poor blood? If so, you may want to purchase some of my awesome stock of surplus Geritol. It works pretty good. I for one would like to read a Muck thought the last few days the internet was up.
Hang in there.
[img]https://encrypted-tbn0.gstatic.com/images?q=tbn:ANd9GcTgORiqk-HQ5F4t3xqcvW51f-tdFOZi-J9HcqAV16rCZE9pW9CP[/img]
Not just you Muck, it is going faster,everything is.
I’ve buried 6 people in 12 months, three under 50, three to cancer, one to weaknesses in an aorta that became deadly after 2 years on statins. Oops.
Everyday comes a new way that could cause me more work, or take money out of my kid’s mouth – or business, same thing.
Everyday, it now seems, we have a new area of violence, a new safety issue, a new danger, that we want DC to fix.
Every freaking day.
Nope, it’s not just you, it is the world.
Next stop is the bottom of the cliff. Guess I’ll take it fast and furious until then. 🙂
@crazyivan: Nope, not short of iron. Just to long in years!
@TE: I’m very sorry for your loses, Teresa. Being a cancer survivor (so far) has made me a believer in just looking around when I feel sorry for myself (not often).. There is always someone (lots of someones) who are way worse off than yourself.
That, of course does not lessen your pain at the lose of a loved one but it does remind you that no one gets out of here alive!
Take it fast and risky (well thought out, of course) between here and where ever we’re going. There is no life without risk, but I can tell you that the older you get, the more risk adverse one gets. Intellectually, that is. Fight it all the way and every now and then take it to the edge. I still cave dive and fly – but I did sell my 1200 Harley Sportster last year for lack of eye/hand coordination.
Don’t let the bastards grind you down, TE….
MA
Sorry, that “loss” not lose.. Damnit anyway..
MA
Totally understand what you mean about becoming more risk adverse with every passing year. Some of the things I’ve did in my youth were obviously never meant to be repeated in my middle age, or older…
And you didn’t have to correct yourself, I think you are articulate, so I read it right, I had to go back and actually look for the typo. I guess it’s because I truly think the sun rises and sets on you, easy to never see the silly finger/eye/brain error.
Don’t worry about me, I have my moments/years, but I’m resilient. Really, really, resilient. Plus I now have four others to stick around to help through this stuff. My wee grand daughter, and my daughter, and my son and his girlfriend have given me more than enough reasons to never let anyone keep me down for long. As for the rest of my life, that is just a waiting game and I am a very, extremely, patient woman when I choose to be.
It is so good to chat with you!
Muck says: Take it fast and risky (well thought out, of course) between here and where ever we’re going. There is no life without risk,
I hit it just like that Mr. MuckAbout, very well said. I am having the time of my life. 52 years old, in great physical shape, some Money in my hand, and four outstanding horses I love to train and ride. We only do this thing called life once, well as far as I know once, push the peddle to da flow.
Always glad to see you post. Be well my friend!