Recent weeks have brought significant sentiment improvement on equity markets. This was due, among other things, to several central banks' announcements of further monetary policy easing. FED President Jerome Powell in his recent statements hinted that despite not bad economic data in the U.S., the central bank is likely to cut interest rates. Meanwhile, members of the European Central Bank have mentioned few times that they will return to asset purchases if needed. This is important because we have a very high correlation between central banks balance sheets (blue line) and the S&P 500 index (red line), representing approximately 35% of global shares.

As you can see, with the amount of total assets increase for Fed, ECB and Bank of Japan, prices of the main stock index in the U.S. have also increased. Let's have a closer look at the current market situation among different groups of investors.

 

High optimism among investors

Over the past week, hedge funds that follow macroeconomic trends and commodity hedge funds have been strongly involved in U.S. shares purchases. Their average net exposure increased from 25% short to over 50% long. Chart below shows that in the past such high long exposure usually meant stock market declines in the short term.

As you can see, this is one of the factors which shows that it is not the best time for investing in stocks. Next alarming signal is involvement in options of small investors.

Over a month ago, retail investors (this group is mostly wrong) bought over 3 million put options (options are gaining in value when stock prices are falling), or 26% of the total volume among this group of investors. What happened next? Stock prices have risen sharply. Currently, the same investors are intensively buying call options (options are gaining when share prices are increasing). Over the week, it was more than 4.4 million options, or 40% total volume of that investors group. For clarity, the greater share of call options in the volume, the greater optimism among those market participants. Therefore, as you can guess , in the past it meant drops of the S&P 500 index, which can be seen on the chart below.

Over the last two years, each time the number of call options exceeded 40% of the total volume among small investors, S&P 500 has experienced correction (red arrows).

Another indicator that we pay attention to is "Dumb Money Confidence", or optimism of the worst-oriented group on the market. Below chart presents, apart from this indicator, "Smart Money Confidence" (the best oriented group) and  S&P 500.

Currently, Dumb Money Confidence is at 81%. Taking into account data for the last 20 years, when the ratio was above 80%, shares were falling at a rate of 22.3% per annum. We would like to point out that investing in stocks when this ratio is at such a high level is subject to a very high risk.

 

Expectations of FED movements and arguments for further rally

Next Federal Reserve meeting is scheduled for July 30-31, when interest rates in the United States are likely to be cut. Market is currently pricing-in 100% probability of a rate cut by at least 25 basis points (0.25%). It means that this reduction is already included in the stock prices. So if it happens, it will not cause another upward movement of the stock market. Looking historically, this situation may even cause stock market declines. Hardly anyone realizes, that during the previous two bear markets of 2000-2003 and 2007-2009, the biggest declines occurred after FED interest rate cuts. Will this happen again?

In recent days, some FED members have mentioned possibility of rate cuts not by 0.25%, but by 0.50%. Investors assess the likelihood of such a strong reduction at over 20%.

source: CME Group

If this happens, it may cause stock prices increases, which, however, will be short-lived, because in the long term market will realize that such a large rate cut is actually a confirmation of the poor economy condition. Chart below shows S&P 500 index performance for the next 250 transaction days (1 calendar year) after the beginning of the interest rate cuts cycles conducted by the FED.

source: isabelnet.com

In 1984, 1989 and 1995, market has positively reacted to interest rate cuts for some time. It should be emphasized, however, that we are now after 10 years of economic expansion, which is the longest period of growth in history.

In the coming weeks, second quarter results will be published by the majority of companies included in the S&P 500 index. It is expected that corporate profits will fall by approx. 3% compared to last year. Nevertheless, they will be "higher than expected", because in the meantime, forecasts have been reduced several times. We have described this phenomenon in the article - "How to conjure results better than expected?" Perhaps, in the short term it will improve quotations, but it does not change the fact that companies profitability on the NYSE is getting worse. Eventually, the market will have to see it.

Looking long-term, S&P 500 quotes (blue line) and earnings per share (orange line) of companies included in its composition are almost always correlated with each other.

source: macrotrends.net

Also one of the factors that could cause temporary continuation of stock price increases is high bond prices. On the chart, you can see ETF which brings together U.S. bonds with maturity over 20 years.

source: stockcharts.com

A possible correction could cause a temporary capital inflows into shares.

The final argument for further increases could be faster than expected return to asset purchases by central banks, for example by the ECB.

 

Summary

High optimism among various groups of investors indicates that the stock market correction is imminent. In addition, expected interest rate cut by the FED is already fully priced in. One also can not forget about the ongoing trade war between U.S. and China. Despite temporary looser rhetoric, President Trump said this week that he is able to impose further duties on imports from China, if necessary.

In addition, from 1 January the S&P 500 index has risen by 20.85%. This result is for period slightly longer than half a year. From 1926, the index gained on average around 10% annually. Furthermore, looking historically, there are also worse months for the stock market ahead. Remind yourself of the famous "sell in May and go away".

As a curiosity, below we present a graph showing 20 valuation metrics of the S&P 500 index where 17 of them are above their historical average, showing how strongly overvalued the market is (red column). Only 3 of them show historical undervaluation of the index (green color).

source: Bank of America Merrill Lynch

In the 6th row of the table there is CAPE indicator (or Shiller PE, one of the most important indicators), which is 75% higher than the average.

 

Independent Trader Team