This week has been an alarming one for equities traders; after weeks of steady progress a selloff dramatically reversed the Dow Jones Industrial Average, wiping out all its gains for this year and leaving it in negative territory. For many investors this all came as a very unwelcome surprise – but some analysts say the signs were there for anyone who recognized them.
Tracking the ups and downs of the stock market since 1970 it’s possible to identify three red flags that, when they all show up together, are always followed by a drop of at least 20 percent. This has happened six times in the last 44 years and every time they’ve been followed by a bear market. It’s not likely to be coincidence either because the connection holds both ways – every bear market has been preceded by these signs. Once they appear the average time before the market starts to fall is about a month, and that ties in well with what just happened.
The first of the three warnings is a high prevalence of investors who’re taking a bullish stance. When that rises much above 50 percent many analysts regard it as a dangerous sign of an overheating market, and it topped 60 percent last December (it’s currently at 56 percent). Overconfidence is always dangerous, and such a high proportion of bulls suggests that the market is getting carried away with itself.
The second indicator is widespread overvaluation of stocks. This can be measured in several ways but the most useful is probably the price/earnings ratio. Since 1984 this has been tracked carefully, and it’s in dangerous territory right now. In fact the ratio for the Russell 2000 index, which tracks the stocks of firms with between $250 million and $2 billion in capitalization, is at its highest level in 30 years. In other words stocks are more overvalued now than they were at the height of the internet bubble or in the heady pre-crash days of 2007. This high level of overvaluation kicked in around the same time as the first flag, late last year.
The historical record tells us that the market has never crashed with only two of the three indicators present, but always has when all three appear. The third is a rapid fall in the percentage of stocks taking part in the bull market. The best way to measure that is to look at the percentage of stocks trading above the average of their price for the last four weeks. At the beginning of July that was 82 percent. By July 24 it had fallen to 50 percent, while at the same time the S&P 500 hit its highest ever aggregate. That’s an almost unprecedented narrowing of the market, leaving almost all of the continued rise in the hands of a small number of stocks. Meanwhile the broader measures, like the Russell 2000, were already starting to drop.
If the pattern holds as it has since 1970 we’re now looking at a sharp fall in equities, of 20 percent or even more. That would be a serious blow to the economic recovery and also calls for some revised investment decisions. This might be a good time to take advantage of falling gold and silver prices, because they could bounce back very soon.