A month ago, I published a piece explaining why the latest stock market bounce was not the start of a bull market but the inception of a bear market rally.
Now this move has continued for longer than I expected, I am more convinced that we’re about to witness a retest of the March lows. But this is not just a feeling: I am basing my views on economic data, market sentiment, and market positioning, and my research tells me we have reached the top of the bear market bounce.
Since the March crash, all the classic traits of a classic bear market rally have surfaced, and it's getting to the stage where investors simply cannot ignore the warnings signs anymore. Here’s why, going forward, I’m sticking to my overall bearish stock market outlook.
Central Bankers Will Pull Liquidity From Markets
Five years ago, Stan Druckenmiller, one of greatest traders of all time, gave a famous speech urging investors to avoid fighting the Federal Reserve’s loose monetary policy stance. “Whatever I do, focus on the central banks and focus on the movement of liquidity, that most people in the market are looking for earnings and conventional measures. It’s liquidity that moves markets,” he said.
Last week, however, Druckenmiller reiterated his position stating only to fight the Fed when net liquidity turns negative.
As central bankers see the stock market rising to new all-time highs, they will begin to draw liquidity from the system, which, according to Druckenmiller, means sometime in June, net liquidity will become negative once again as it did in mid-February — and we know what happens next.
Retail Has Suddenly Become Interested in the Stock Market
In the last few weeks, you may have noticed friends, family, or coworkers who never talk about the stock market finally showing interest. This is exactly what’s happened. It appears retail investors are already ultra-bullish on “stocks”, something you don’t see at the start of a new bull market.
Robinhood, a zero-commissions trading app has experienced record-high activity, so much so, that their platform has crashed multiple times trying to deal with the excess demand. Trade volumes have also increased exponentially on other popular brokerage platforms like ETrade and Ameritrade.
Whether the large influx of activity is due to investors capitalizing on the market correction or exercising their stimulus checks, investors need to consider the possibility that everyone is already bullish.
The Biggest Disconnect Between Economic Fundamentals & Stock Prices On Record
Major indices, like the Nasdaq and S&P500, are approaching new all-time highs while forward-looking economic activity and confidence continue plummeting. Atlanta Fed’s nowcast indicates a -52.8% decline in GDP and the ISM shows a steep contraction in business confidence.
Mean reversion occurs eventually. It’s whether business confidence catches up with the stock market or visa versa. Similar economic environments over history: 1930, 2001, and 2007, point to the latter scenario.
We’ve Reached Peak Euphoria In Only One Month
Wall Street analysts have capitulated on bearish outlooks, while the fundamentals remain bearish. Goldman Sachs has removed its 2400 S&P500 forecast, saying, “the powerful rebound means our previous 3-month target of 2,400 is unlikely to be realized.”
In the options market, bullish positioning is reaching exhaustive levels as investors purchase a record amount of call options (a bullish bet on the market).
Meanwhile, the put-call ratio, the proportion of put buyers to call buyers, has entered bubble status. No one is willing to buy protection when they need it most, which is a signal of extreme bullish positioning, a signal that the bear market rally is on its last legs.
In the futures market, “smart money” remains short S&P500, Nasdaq, and Dow Jones futures. Usually, extreme positioning leads to a reversal in trend, but investors looking to protect stock positions tend to short S&P500 futures as a hedge. The smart money may be wrong for now, but their persistence and willingness to pay for protection confirm that they see risks ahead.
Almost Every Stock In the S&P500 Is Above Trend
Simple technical indicators like simple moving averages may be useless at predicting the future, but they become useful when identifying market inflection points. The percentage of S&P 500 members trading above the 50-day moving average is the highest in nearly three decades. “Extreme bullish and bearish measures are generally followed by the opposite market action in the short-term.” says market analyst Lance Roberts.
The Bullish Case, “Don’t Fight the Fed”, Is Not a Convincing Investment Strategy
Not only is it a poor idea to base your investment decisions on one catalyst, but history shows relying on the Fed to prop up your investments usually backfires, especially if you’re late to the party.
If you ask any Japanese boomer about retiring on a stock market portfolio they would laugh you out the room. After their major bubble burst back in 1990, the Nikkei, Japan’s major stock exchange, has fallen more than 50%, and that’s even with major government and central bank intervention.
The Fed is starting to look more and more like the Bank of Japan after they make every policy decision. They are running out of ammo having already dropped interest rates to zero, bought junk bonds, and started yet another round of QE (quantitative easing).
What we’re witnessing is the Japanification of the U.S economy, so we could see the peak in western-world equity markets over the next few years.
So, What Next?
First, this is not a call to go 100% net short the market. Outright shorting is a dangerous approach since you’re betting against a system that everyone is trying to prop up. Though I have a short bias on the market, I am still holding positions in stocks likely to generate positive earnings in a post-COVID-19 world, such as Zoom and Walmart.*
If you’re a long-only, passive investor, now’s the best time to take some profits based on declining economic fundamentals, over-bullish technicals, and over-bullish positioning in the market.
If you run a long-short portfolio, now is a good time to take profits by reducing long exposure. Holding an overall short bias or net-short position is a prudent risk management move going forward.
Like many others, you may be sitting on the sidelines with severe F.O.M.O, thinking about reentering the market. But your chances of making money will improve if you wait for economic data to turn bullish (learn how to do that here), and wait for volatility to return to investable levels; around a VIX reading of 15. Because when someone of Druckenmiller’s caliber says stocks have the worst risk-return profile ever, maybe the right move is to do nothing at all and wait for the chaos to subside.
*Disclaimer: The author holds a position in Walmart, but not in Zoom at the time of writing. This article is not investment advice.