Will The Market Continue Its Plateau?

Today the market sold off slightly as it maintains the plateau it has been at since mid-December. This reminds me of the market in August where it hit new highs, but barely moved. In the few months leading up to the election, I had noticed volatility was low historically when you look at other pre-election years. This time the market is experiencing historically low volatility compared to other post-election time periods. In fact, going all the way back to 1896 the Dow Jones Industrial Average has had the lowest percentage decline from a closing high between Election Day and the inauguration ever before. Secondly the total performance for the Dow in that time period is the second best ever. The best is the late 1928 rally which led up to the 1929 crash. This current market is similar in valuation to that market although calling for another Great Depression would be hyperbolic.

I usually think these types of analysis are meaningless because any market can perform in a unique way in a short period of time without necessarily following past outcomes. The reason why I am focusing on the small movements is to try to tell where the top of this market cycle will be. The chart below is all the evidence you need to want to look for clues about a top. The median enterprise value to sales ratio for S&P 500 firms is the highest ever. It’s much higher than the bubble in the late 1990s. This bubble is more broad based than that one which was mainly was focused in tech. That’s why the aggregate enterprise value to sales ratio is lower in this market. I doubt it will reach the 2.7 peak it hit in the tech bubble. The market is ripe for a large correction soon.

If you need more data that the market is at bubble valuations, the chart below satisfies you. The chart shows the ratio of the Wilshire 4500 Index to the money supply and the ERCI leading economic indicator index. This shows the market is above the 95^th percentile in terms of valuation. Sure, it can get to the 99^th percentile, but buying stocks now is picking up pennies in front of an oncoming train. I think the market will crash and underperform for several years to work off such high valuations.

As I’ve mentioned before, earnings growth is expected to drive the market higher in 2017 because the market’s multiple is already stretched. This growth is expected to come from energy firms. As you can see below from FactSet’s chart, the energy sector’s earnings growth is expected to be 359.2% in 2017. I don’t think the earnings growth will be able to reach that mark if oil prices decline.

My evidence for potential oil price declines is in the chart below. It shows the net speculative long positions in oil futures. This speculation of futures contracts has reached the level last seen before the oil crash which occurred in late 2014 and 2015. Although you would think oil prices would be determined by supply and demand, the financialization of the commodity means speculators also have a say in the direction of the price. Speculators play an important role in price discovery, but when they all lean in one direction, sharp reversals can occur, leading to excess volatility.

According to Raoul Pal physical oil producers are the shortest in history because they think the price of oil is way too high. This means the speculators in finance who are leaning long are manipulating the price higher than it should be. A correction needs to flush them out. The chart below shows the U.S. Dollar broad trade weighted index compared to the price of oil. The last time it was this far below the price of crude oil was prior to the crash in 2014. It signals oil may fall into the $30s which would put a damper on oil earnings growth in the second half of the year.

I find the evidence of oil’s decline convincing enough to make it part of my assumptions with regards to future inflation and monetary policy. The chart below shows the year over year price changes in crude oil and the Citi Inflation Surprise Index for America. It’s not a surprise that the index has been showing missed expectations for inflation given the low inflation we’ve seen in this recovery. What’s worth pointing out is that the recent oil price rally has pushed the inflation indicator higher. In other countries, it has moved even higher than America’s index. If oil falls back down, then the expected inflation index will start moving lower again. As you can see below, by the middle of the year if oil is at $55, it will be up 10% year over year. If it falls to the $30s again, this will be negative. This means the Fed will have a tough time raising rates as inflation won’t need to be fought forcefully.

The final chart shows the growth rate in world export value since prior to the recession. The growth rate has been putrid as it hasn’t even reached the 1% compound annual growth rate line. Therefore, tariffs are especially harmful now. It may be the straw that breaks the camel’s back and sends world export values lower.

Conclusion

            The market is expensive. I will keep explaining this in different ways until we see a correction. It is at unprecedented valuations and must be avoided. The case to be bullish is dependent on energy firms reaching annual earnings growth of 359.2%. I think oil is about to crash because the speculators are too overweight the commodity. I think this pressures inflation expectations and sends yields falling again. The chart below shows the countries with deflation declining. I think this trend will reverse as the reflation trade ends. On a separate note, global trade growth has been anemic. Trump’s tariffs won’t help the goal to get growth higher.