With the S&P 500 up more than 25% in 2019, the risk of a market pullback, correction or even bear market grows daily. While the market may continue to rise in the near-term there are a number of reasons investors and traders should be wary. With this in mind, it is only prudent to begin trimming profits if only to reallocate portfolios in preparation for 2020.
#1 - The Earnings Outlook - If a company’s earnings power is the basis of its value it is the outlook for future earnings growth that drives the value of its stock. The outlook for future S&P 500 earnings has been in decline for over a year. While the S&P 500 moved up to set a new all-time high the outlook for 2019 EPS growth fell from over 11% to less than 0%. That’s a very unstable foundation for the market to be valued on.
Now, looking to 2020, there is an expectation for near-double-digit EPS growth but there’s a problem. First and foremost, that near 10% is on top of 2019’s weakening performance. Secondly, CEO’s and CFO’s are hesitant to offer 2020 guidance due to high levels of uncertainty in global markets. With this in mind, there is a real chance that once CEOs begin to issue guidance it will be much lower than the analyst’s consensus estimates. Weaker than expected guidance will result in a sharp downward revision to 2020 estimates. If that happens we can expect the S&P 500 fall very quickly too.
#2 - The Technical Picture - The SP 500 is trading at a fresh all-time high, above a key resistance target, and getting weaker by the day. The momentum indicators MACD and stochastic agree; the market is overbought, overextended, and ripe for a correction. The most telling indication is in the MACD. The MACD is diverging from the new highs in a way that suggests core weakness in the broad market. Core weakness opens the door for a bearish shift in momentum. A bearish shift in momentum will at least cap gains in the near term. If the bears are able to establish a foothold they could drive this market down to retest support at 3,150 or lower, a move of at least -2.2%.
Longer-term, on the weekly charts, the risk to the S&P is even more obvious. The indicators show overbought, divergent conditions but also an index that is more than 20% above the secular trend. At these lofty levels, the market needs to correct just to keep the bull market alive and healthy.
#3 - The Valuations - The S&P 500 is trending higher even while the outlook for earnings growth deteriorates and that is leading to high valuations. The S&P 500 is now trading near 18X its forward earnings consensus estimate, not the highest it has ever traded but high enough to cause concern. Historically, when the S&P 500 is trading at such high levels the market tends to correct. The mean S&P 500 P/E is near 15.75X, the median 14.75X earnings, numbers that suggest the S&P 500 could contract 10% to 20% in the not-too-distant future without damaging the bull market. A decline of 20% is consistent with the long-term technical outlook too. Such a move would bring the S&P down to the 2,500 level, very near the lows of December 2018, and back to trend.
#4 - The Trade War
- The trade war and specifically trade optimism
and hope for a Phase One Deal have been a major driving force of the 2019 bull market. That is very bad. The rally is driven on market expectations that are likely to be left unfulfilled. That puts the S&P 500 in a no-win situation. At best, the market is looking at a sell-the-news event because any deal we get won’t be as much as the market wants. At worst, the market is set up for major disappointment when trade talks disintegrate as it appears is happening now.