Saturday, February 25, 2017

Warning Sign: The Last Time This Happened In Stock Markets An Epic Crash Followed

SOURCE

The Dow Jones continues to hit record highs and yesterday it reached a milestone not seen since January of 1987.
Back then, the band Starship was at the top of the charts with their hit song Nothing’s Gonna Stop Us Now, which appears to also be the rallying cry of Wall Street, Main Street and 1600 Pennsylvania Avenue today.

Of course, for those who are familiar with their history, that year didn’t end up so well for investors. On ‘Black Monday’, October 19th, 1987, the U.S. stock market suffered the largest crash in history with the Dow Jones losing 22.6% in value, amounting to roughly $500 billion in losses by the end of the trading day.
And if the exuberance of 1987 is any guide, we may be looking at a similar set of events over the course of 2017:

The Dow finished with a more than 30 point gain Thursday and hit its tenth record closing high in a row.
…
But what makes this rally truly historic is the fact that the market is also continuing to hit new highs during this epic run. That hasn’t happened since Ronald Reagan’s second term.
The Dow wound up hitting 12 consecutive records in January of 1987, and it went up 13 straight days overall.
Of course, market historians might ominously note that 1987 was also the year that the stock market suffered its worst one-day drop ever. (CNN Money)

The records in and of themselves aren’t necessarily an indicator of a coming crash, but they should certainly be raising warnings signs, especially considering that many experts, including traditional bulls and bears, are noting that markets have gone up too high, too fast.

“We’re due for at least a rest, if not a correction. We’re way overbought,” said Steve Massocca, managing director with Wedbush Securities. Massocca said the market will continue to focus on data, with a truck load of reports next week on everything from fourth-quarter GDP to inflation and auto sales. The other focus, of course will be on Washington. (CNBC)

But don’t take our word for it. Here is what the Federal Reserve had to say about stocks just a few months ago, before we started breaking historical records like we did on Thursday:

Finally, the chart below shows the median price/revenue ratio of S&P 500 component stocks, which recently pushed to the highest level in history, exceeding both the 2000 and 2007 market peaks. In recent quarters, the broad market has deteriorated, even in the most reasonably valued decile of stocks, but the most richly valued decile has held up for a last hurrah, as it did near the peaks of previous bubbles. This dispersion has created a headwind for hedged-equity strategies in U.S. stocks, particularly value-conscious strategies, but investors should understand that beneath the surface of this short-term outcome is singularly the most extreme point of overvaluation for the median stock in history.

As the analysts at Zero Hedge highlight, we are literally at a point where major banks and analysis firms are justifying corporate valuations at 20+ price/earnings ratios with “animal spirits” as a driving force.
No, seriously, we’re not kidding:

Carbon-based traders of a certain vintage – which excludes today’s 20-year-old hedge fund managers – may recall a time when a 15x P/E was considered “fair.” Not any more. In fact, according to a new analysis by Barclays’ equity strategist Keith Parker, which tries to factor in so-called “animal spirits” as a driver of valuation has found that 20x P/E is perfectly normal and fair for the current market, further demonstrating just how deep into the goalseeking rabbit hole US capital markets have fallen.
First, to prove we are not joking, here is Barclays explaining why it is important to quantify animal spirits as a input factor of “permanently high plateaued” P/E multiples:

Core drivers of the P/E multiple and animal spirit indicators
In order to estimate the effects of “animal spirits”, or the potential effects of some of President Trump’s agenda, we first model the S&P 500 P/E using the core fundamental drivers of equity valuations. We then compare the residual from the model (actual minus fitted P/E) to various indicators of “animal spirits” or potential policy changes, including: tax policy, credit spreads, inflation, macro volatility, long-term growth expectations and corporate/consumer sentiment data.
The punchline: “Based on our findings we incrementally add other variables to build a more comprehensive P/E model, to better evaluate the potential effects of “animal spirits” on equity valuations”
At this point Barclays provides numerous pages of tortured, goalseek “empirical evidence” to extract the result it is after. What it “finds” is that what was once a “fair” 15x P/E is now really 20x P/E thanks to, drumroll, animal spirits
Full report: How A Major Bank “Calculated” That 20x P/E Is Now “Fair Value”

We’re not going to attempt to predict what happens next, but history suggests that extreme valuations, consecutive all-time record highs, and media exuberance often lead to the same end result.
But this time it’s different, right?
Perhaps. But we suggest preparing for the worst just in case the experts are wrong. That may include re-balancing your existing portfolio with precious metals assets, moving some of your holdings into cash, and positioning yourself with essential supplies in anticipation of a widespread credit event like the one witnessed during the crash of 2008.