Crash Prone US Stock Market

The S&P500 resumed its recent decline by dropping almost 1.3% last week. While still fairly light, volume was notably higher during this down week compared to weeks when the S&P rose. And as expected, volatility crept up somewhat; that said, it’s still very close to the lows of the summer and the year.

The technical distribution pattern continues to gather strength. For the year, the S&P is virtually unchanged through the first week of August. And the 50 day moving average is clearly starting to converge with, or “pinch”, the 200 day moving average. Ultimately, when this happens, a “death cross” will have formed (the opposite of the “golden cross” that formed in mid-2009 and again in early 2012) and a lot of traders will start to sell, or at the very least reduce their buying of, US stocks. Of course this hasn’t happened yet. And the 200 day moving average is still comfortably sloping upward, so the current bull market run has not ended.

Also, the market internals have not improved. While index prices have remained stuck near all-time highs, many measures of market breadth are sending extremely bearish signals. This divergence, historically, has never lasted very long.

In US macro news, last week’s reports were fairly weak. Construction spending came in well below expectations. ISM manufacturing also disappointed. Factory orders were a disaster; orders ex-transportation were the weakest since 2009. International trade was bad—the trade deficit was worse than expected. July payrolls came in just about as expected, but the labor force participation rate was stuck at multi-decade lows. That means people who can’t get decent jobs simply stop looking for work, and are no longer counted as “unemployed”. On the positive side, only ISM services stood out with a meaningfully better than expected result.

Finally, it’s important to remind everyone that almost every time when US stock market crashes have occurred over the last 100 years or so, two conditions were in effect. First, valuations—as defined by long-term measures such as the Shiller PE ratio—were extremely stretched. Second, market internals—defined as measures of breadth such as New Highs minus New Lows—were diverging bearishly. This situation is presented in great detail by money manager John Hussman. But the bottom line is this—both of these conditions are in place right now. And so stock market investors ought to really assess their exposures to equity risk, and unless they’re fully prepared to ride out losses as potentially massive as the ones seen in 2000-2002 and 2009-2009, then they may wish to reconsider their conviction that this time nothing really bad will happen.

A market crash may not be around the corner, but if one were to occur now, it would be no surprise to anyone who’s studied history.

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