Equity Markets and the Ghost in the Machine

How would you value a company that lost $666.6 million in the first half of 2017 … burns $2.0 billion in cash a year … and just sold $1.5 billion in junk bonds to fund operations?

If you’re the stock market, you’d give that company — Tesla — a pass. Year-to-date, the shares are up by more than 70%. Talk about a disconnect!

The fact is right now the fear of missing out on the next big thing – in a world of excess liquidity – shifts focus away from fundamentals. And pumps up companies that may normally be left behind.

Plus, it underscores a real danger: how complacent the market has become in pricing risk and valuing assets.

I spoke about this in my intermediate forecast in June.

After all, world central banks bought nearly $11 trillion in assets over the last nine years. And that rising tide lifts assets and distorts fundamentals.

Unfortunately, the music’s about to stop. And that’s because economic conditions are finally at a place where central banks are slowly tightening ultra-loose monetary policy.

A pullback in the money-flow spigot poses a significant risk to inflated asset prices that have become dependent on easy money. Even the slightest disruption in those flows puts overvalued assets in a vulnerable position.

And that could blow up in everyone’s faces.

That’s why it’s no surprise why the Fed’s judiciously telegraphing their plans and warning investors that change is coming … to prevent another 2013 “taper tantrum” episode.

But this time, market dynamics are much different — and could be much worse. Consider …

  • The S&P 500 Index trading at 21 times trailing 12-month earnings (TTM)
  • Nasdaq-100 trading at 25.4 times TTM
  • Google trading at 34 times TTM
  • Amazon trading at 249.2 times TTM

And with the second-quarter earnings season winding down, shares now look toward favorable tax and regulatory policies coming out of Washington, D.C., for more upside.

Good luck with that in the foreseeable future!

Unfortunately, it gets worse.

The probability of sudden and sharp market sell-offs is exacerbated by the recent trend of passive investing. Investors are moving their nest eggs away from active managers in favor of ETFs in droves. And that’s contributed to blistering gains in the major averages.

Reason: These ETFs are buying the same group of stocks that could be terribly overpriced, such as FANG shares (Facebook, Amazon, Netflix and Google).

These ETFs don’t hold cash. And they’re forced to sell their share basket when the investors wake up to the nose-bleed valuations and hit the sell button. This selling pressure exacerbates market declines when everyone heads for the door at the same time.

Frightening, indeed.

And a bearish technical backdrop is also calling for a larger corrective setback ahead.

The S&P 500 traded inside of a tight trading range from late July into this week. In fact, closing prices over that period fell inside of an extremely narrow 8-point range.

Like a coiling spring, the index is now making its move.

First, there was a false upside breakout into record high territory. But it failed miserably. And sharp downside in the major indices throughout the week confirm the bearish bias.

Second, the negative outlook is also confirmed by our E-Wave cycle forecast that calls for a decline into early October. The decline is followed by a brief corrective bounce, before a sharp selloff into mid-January.

What’s an investor to do?

First and foremost: Manage risk. A prudent move is to take some profits at these lofty levels. This also frees up cash for deployment in the coming months at more-advantageous prices.

More aggressive investors might consider purchasing January SPDR S&P 500 put options or buying inverse ETFs like ProShares UltraShort S&P 500 (SDS) or ProShares UltraShort QQQ (QID) on rallies.

Cheers,

John Isaacson

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Comments 3

  1. Nick August 12, 2017

    It is about time someone told it like it is, Thank You, John

    Reply

  2. Steve Nellissen August 12, 2017

    Who is John Issacson? Looks like Larry’s wave chart, why no comment on the current sharp divergence.

    Thanks. As always,

    Steve

    Reply

  3. H. Craig Bradley August 12, 2017

    BE A REAL CONSERVATIVE

    New acronym symbolizing market speculations: Fear of Falling Behind or “FOB”. First its FOB, then for market speculations gone awry, its SOB. Manic Markets, Manic Emotions, then Panic. Wise to avoid all of the above adverse outcomes.

    Reply