Business

The stock market is on fire. History shows that won't last

Posted January 3, 2020 12:13 a.m. EST

— The melt-up on Wall Street has reached historic proportions.

Last year wasn't just the S&P 500's strongest since 2013. Markets wowed investors late in 2019 by showing an uncanny ability to trade higher, seemingly every hour of every day.

Bespoke Investment Group ran the numbers and confirmed that Wall Street has rarely experienced a period as decidedly bullish as late 2019.

The firm calculated how often during the trading day the S&P 500 was up versus the prior days' close over a rolling 50-day trading period. And Bespoke found that in late December, the S&P 500 was in the green on an intraday basis over 65% of the time — a level surpassed only a handful of times since the firm's intraday numbers began in 1984.

That extremely bullish pattern continued Thursday. The Dow kicked off 2020 by climbing more than 300 points, or around 1%.

"It's like we have a TiVo on: We're just watching the same show, day after day," said JJ Kinahan, chief market strategist at TD Ameritrade.

Those stellar gains have padded Americans' investment portfolios. And the market boom could instill further confidence among households and CEOs in the sustainability of the economic expansion.

'The fun didn't last'

Yet history shows that such consistently positive market performance doesn't last. And it can actually be a negative omen.

After the past six times when the S&P 500 enjoyed such positive returns, the index averaged a slight decline of 0.4% a month later, according to Bespoke. Sideways trading wouldn't be so bad given how much stocks have spiked.

The problem is that three months later, the S&P 500 was down every time, averaging a decline of 6.4%, Bespoke found. And even within six months, the index was down by an average of 3.6%.

"The fun didn't last," Bespoke co-founder Paul Hickey wrote in a note to clients on Thursday. "If history repeats itself we'd see sideways action in January and February and outright declines in March and April."

That's what happened in late 2018 when US stocks tumbled after a similar period of extreme bullishness.

Easing trade war and easy money

None of this means the bull market in stocks is about to end. There are good reasons for the market rally. The United States and China have stopped firing shots in the trade war, for now at least. The two sides reached a phase one trade deal that prevents new tariffs from getting imposed and rolls back some existing tariffs.

Although the deal does not end the trade war, it does ease the biggest risk facing the United States and global economy.

"We don't expect a global or US recession, and anticipate a modest growth and profits rebound now that worst case trade outcomes may be avoided," Michael Cembalest, chairman of market and investment strategy at JPMorgan Asset & Wealth Management, wrote in a note to clients.

The melt-up in stocks has also been fueled by easy money from the Federal Reserve. The US central bank cut interest rates three times last year. Those rate cuts made risky stocks look more attractive relative to ultra-safe government bonds.

Moreover, the Fed has injected vast amounts of cash into the financial system in a bid to ease stress in the overnight lending market. Although the Fed's rescue of the overnight lending market may not have been intended to boost stocks, analysts believe it's doing just that.

Extreme greed

There is an obvious risk that market sentiment has gotten ahead of fundamentals. The CNN Fear & Greed Index is sporting a score of 97, essentially signaling maximum greed.

Market valuations also look elevated. The S&P 500 is now trading at 18.9 projected earnings, according to Refinitiv. That's up from just 16.9 in early October and well above the 10-year average of 15.2.

The market valuation of the S&P 500 is roughly 199% of the nation's GDP, according to JPMorgan. That's in the 99th percentile historically.

Similarly, JPMorgan said that the S&P 500's enterprise value is 2.5 times sales. That's also in the 99th percentile historically.

However, other metrics, including free cash flow yield and the S&P 500's earnings yield relative to 10-year Treasuries don't look out of whack with recent history.

"Valuations are high, and we are starting to see cracks in risky and poorly underwritten investments," JPMorgan's Cembalest wrote. He pointed to investors avoiding the energy sector after a decade of weak performance and the recent poor performance of some 2019 tech IPOs. (That's not to mention the implosion of WeWork's attempted IPO).

But valuations are notoriously poor timing tools. High valuations can go higher.

And betting against this bull market has been a recipe for disaster.

Horseman Capital Management, one of the most bearish hedge funds in the industry, suffered a staggering loss of nearly 35% last year at its flagship fund, according to a spokeswoman.

Still, TD Ameritrade's Kinahan warned investors not to get lulled into a false sense of security by the string of records on Wall Street.

"Things don't go up forever," Kinahan said. "You have to be cautious about saying, 'Everything is at all-time highs, so I'm all in.'"

The key will be whether Corporate America can live up to the hype created by Wall Street. Quarterly earnings have to essentially grow into the lofty expectations built up by the market.

"The reality has to meet the anticipation," Kinahan said.

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