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Summary Historical bull and bear market cycle suggests we are overextended. Earnings are weak, valuations are high. Interest rates are on the way up. This is probably the most hated bull market in history. All along, the bears have been in denial and have been calling for a big crash. To their dismay, the S&P 500 kept moving up and continued making new highs. The bulls have completely demolished the bears. It has reached a point where the bulls don’t give importance to the weak data points; they are happy concentrating on the few positives that still exist. With this backdrop, I want to short the US markets because I believe the markets are ripe for more than a 10% correction with limited upside risk compared to the possible downside. I shall use the historical bull and bear market cycles, the presidential four-year election cycles, the earnings performance and the market valuations to prove my point. As this is a contrarian call, I don’t expect many to agree with me. Previous bull and bear market runs Bull Market data The history of bull market cycles is an important guide, which gives us an idea about the current leg of the bull market. The second half of the 20th century witnessed strong bull runs. I have chosen to study the market cycles from 1942 to the present date; the selected time frame is skewed in favor of the bulls. The first half of the last century wasn’t considered because it had to deal with two world wars and “The Great Depression”. The economical and the geopolitical situation, though fragile, aren’t comparable to that of the early 1900s. Bull Markets with at least a 20% rise, without a 20% drop on a closing basis from 1942 till now SL Start End No of Months % Change 01 28-Apr-42 29-May-46 49.7 157.7% 02 19-May-47 15-Jun-48 13.1 23.89% 03 13-Jun-49 02-Aug-56 86.9 267.08% 04 22-Oct-57 12-Dec-61 50.4 86.35% 05 26-Jun-62 09-Feb-66 44.1 79.78% 06 07-Oct-66 29-Nov-68 26.1 48.05% 07 26-May-70 11-Jan-73 32 73.53% 08 03-Oct-74 28-Nov-80 74.9 125.63% 09 12-Aug-82 25-Aug-87 61.3 228.81% 10 04-Dec-87 24-Mar-00 149.8 582.15% 11 21-Sep-01 04-Jan-02 3.5 21.4% 12 09-Oct-02 09-Oct-07 60.9 101.5% 13 20-Nov-08 06-Jan-09 1.6 24.22% 14 09-Mar-09 ? 82 215.54% Average 52.59 145.40% Maximum 149.8 582.15% Source: BofA Merrill Lynch Global Research, Bloomberg Both in longevity and percentage rise, this market has come a long way and is placed in the third and fourth position respectively. However, the conditions during this bull run are different because the central banks have never printed such massive amounts of money around the world. The excess liquidity was plowed back into the stock markets in search of better returns because gold and a few other base metals peaked in 2011 and have been in a downtrend ever since. Though, this argument holds merit, the current situation is changing. The US Fed has long back stopped its bond purchase, it has gone ahead and raised rates for the first time in a decade. The cushion of the excess liquidity made available every month isn’t there anymore. We shall see higher rates in 2016 and the liquidity situation is likely to tighten further. In the absence of “The Fed Put”, the law of averages should catch up and pull the markets down. Bear Market data Bear markets with at least a 20% drop, without a 20% rise in between on a closing basis since 1942 SL Start End No of Months % Change 01 29-May-46 19-May-47 11.8 -28.47% 02 15-Jun-48 13-Jun-49 12.1 -20.57% 03 02-Aug-56 22-Oct-57 14.9 -21.63% 04 12-Dec-61 26-Jun-62 6.5 -27.97% 05 09-Feb-66 07-Oct-66 8 -22.18% 06 29-Nov-68 26-May-70 18.1 -36.06% 07 11-Jan-73 03-Oct-74 21 -48.2% 08 28-Nov-80 12-Aug-82 20.7 -27.11% 09 25-Aug-87 04-Dec-87 3.4 -33.51% 10 24-Mar-00 21-Sep-01 18.2 -36.77% 11 04-Jan-02 09-Oct-02 9.3 -33.75% 12 09-Oct-07 20-Nov-08 13.6 -51.93% 13 06-Jan-09 09-Mar-09 2.1 -27.62% Average 12.28 -31.98% Maximum 20.7 -51.93% Source: BofA Merrill Lynch Global Research, Bloomberg The average drop during a bear market is 32%; from the all-time high such a fall will take the S&P 500 to 1,452, a level unimaginable now, but that’s what history suggests. I’m not suggesting we will go down to those levels now, even a 20% fall will be highly profitable for us. The risk is, what if this is the mother of all bull markets and the bull run extends by another 70 months with a 300% rise. Anything can happen in the markets; hence, we shall use a stop loss to protect our capital. 2016 is the presidential election year in the US, let’s analyze the stock market performance before and after the new president is elected. Presidential year market performance According to various studies, the stock market gains 9-10% during the first two years of the new president, whereas, the third and the fourth year are comparatively more bullish, yielding higher returns. History suggests a limited upside risk in the next two years; however, since 1952, the last seven months of the election year have yielded positive results but two aberrations have occurred since 2000. The S&P 500 returns from January to March in the election year are mildly positive followed by negative returns in April and May, states a UBS report. I expect the markets to fall during the first five months. Though, the cycles indicate a possibility, stock market returns are closely linked to earnings and valuations. We shall analyze these in the next two sections of this article. There’s a slowdown in earnings Let’s look at a few data points on earnings. According to Bloomberg , the second and third quarter of 2015 have seen negative profit growth for the S&P 500 companies. The expectations for the 4Q 2015 earnings are also negative. A Thomson Reuters report states that compared to 26 positive EPS preannouncements by corporations, there were 86 negative EPS preannouncements by the S&P 500 corporations for Q4 2015. The negative/positive preannouncements ratio in Q4 2014 was 5.1 and in Q4 2015 was 3.3. Both readings are above long-term aggregate ratio of 2.7 taken since 1995. This indicates that the companies are not able to meet their expectations and guidance. Though, Thomson Reuters expects earnings to pick up in Q1 and Q2 of 2016 by 3% and 4% respectively, the current quarter has experienced a downward revision for seven of the ten sectors of the S&P 500. With the current trend, I won’t be surprised if we see negative revisions for the first and second quarters of 2016 going forward. Though 43% of the companies have reported revenue above analyst expectations in Q3 2015, it’s below the long-term average of 60% and lower than the last four quarters’ average of 52%. This shows a declining trend. However, Thomson Reuters states, on the earnings front, 70% has beaten analyst expectations, which is above the long-term average of 63%, and in line with the average of the last four quarters at 70%. In Q3 2015, the share-weighted profits were down 3.3%, the worst figure since 2009, states Bloomberg. Low energy prices and a strengthening dollar are negative for revenues as well as profits. After the first rate hike by the US Fed in almost a decade, the dollar is likely to strengthen further in 2016, with another 0.50-0.75% of rate hike expected by the experts. Some more negative signs for the stock markets In the first nine months of the year, Standard & Poor’s Ratings Services has downgraded US companies 279 times compared to 172 upgrades, this is the worst figure since 2009. Even Moody’s Investors Service has downgraded the credit rating of 108 US non-financial companies against 40 upgrades in the month of August and September. This is the most two-month period downgrades since May and June 2009. According to one metric followed by Morgan Stanley, the ratio of debt to earnings before interest, taxes, depreciation and amortization for investment-grade rated companies was 2.29 in the second quarter. In June 2007, just before the start of the crisis, the same ratio was 1.91. The Wall Street Journal has raised concerns about the balance sheets of the US companies. According to Casey research , the US companies have issued $9.3 trillion in new debt since the financial crisis. The companies have issued record bonds both in 2014 and 2015. Bloomberg business reported that the S&P 500 companies spent 104% of their profits on share buybacks and dividends instead of using it to invest in their business. The last time share payouts crossed 100% was in Q2 2007, just before the end of the bull market. A lot has been written about the junk bond market crash recently. Warning signs are all over the place. What’s the CAPE ratio indicating Are the markets over or undervalued according to the p/e ratio? We use the popular CAPE ratio also known as the Shiller p/e for our study. Shiller p/e Mean: 16.7 This is a popular ratio having both its followers and critics. Though, the reading during the dot-com bubble and Black Tuesday was higher compared to current readings, all other tops have formed at or below the present value. We might not fall just because the ratio is high, but it warrants caution. What does all this indicate We have used multiple studies to arrive at our conclusion about the current state of the bull market. The cyclical study, the drop in revenue and earnings, the red flags in the bond markets, high valuation compared to historical averages all indicate that the average investor should be careful about his holdings. With the US fed tightening interest rates, the trajectory of the rates is on an uptrend. Though, the US economy has displayed strength, the commodity markets, the energy markets, the slowdown in the Chinese economy don’t bode well for the bull run to continue. The markets will likely see a drop in 2016 and we want to go short the S&P via the ETF route. How to take advantage of the drop in S&P 500 Let’s look at a few options one can use to benefit from a drop in the S&P 500. Shorting futures It’s the favorite tool used by professional traders to benefit from a fall. However, it might not be a suitable option for the inexperienced trader, because you have to maintain a margin account to enter the trade. You have to actively manage your positions, you can’t short it and forget it. Buying puts The risk is limited in this trade, however, time value eats into the option premiums. Even if the markets remain at current levels, you will lose all your money if you buy at-the-money or out-of-the money options. Professional traders use complex options strategies to limit their risk and benefit from a fall. To benefit from options, you have to get both the timing, direction and the extent of the fall correctly, which might be difficult. Buying inverse ETFs Leveraged inverse ETFs like the ProShares UltraShort S&P 500 ETF ( SDS) Leveraged inverse ETFs can be bought and sold like stocks. SDS is -2x inversely leveraged against the S&P 500, which means, if the index falls by 1% in a day, the SDS ideally should gain by 2%. In the short term, the correlation is maintained; however, as the calculations are done on a daily basis, over the long term, the correlation is not perfect and can reduce well below 2 times. It’s called as beta-slippage. If the markets rise by 1%, your investment in the SDS will drop by 2%, hence, the risk and reward are maximized. As I expect most of the fall to happen during the first five months, I have advised a buy on SDS to profit from the leverage. In case you are not comfortable with the option of using 2x leverage, you can also buy the ProShares Short S&P 500 ETF (NYSEARCA: SH ), which is -1x inverse correlation to the S&P 500. Here, your risk and reward both are lower compared to SDS. If the markets make a new high and the S&P 500 trades at 2,175 levels (2% more than the current all-time high), we shall close our position and accept our assumption to be wrong. In reference to the current S&P 500 levels, the stop loss is around 5% and the profit objective is more than a 10% fall on the index. Conclusion Calling a top is very difficult, but the indications of a fall are building up. I believe the markets are ripe for a fall and investors should use this opportunity to profit from the fall. I recommend a buy on SDS at the current level of $19.54. Scalper1 News
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