Recently, some professional traders have warned that the market is extremely overbought, that stocks are obscenely overvalued, and that a number of respected indicators such as the Shiller P/E CAPE ratio are flashing warning signs. The Shiller P/E, for example, is just above 30 when the average is 16.8.
In a recent article, Robert Shiller, creator of the Shiller P/E, explained how U.S. stocks now could be heading for a bear market, adding that “my analysis should serve as a warning against complacency.”
Complacency is the perfect description of this mindless market and how many investors feel about stocks. Sentiment indicators reflect swelling exuberance as long-term investors watch their portfolios grow. (Recently, more than a few people have bragged to me how much money they’re making, which is always a red flag.)
Although investors are not buying individual stocks like in the past, passive index buying is all the rage, especially with exchange-traded funds. Veteran traders and investors know how this story will end (badly), but no one can predict when. The longer we go without a correction, the more severe the eventual correction will be.
Warning: Since the 2009 lows, U.S. stocks are up more than 260%, the second-longest bull market ever, which should put you on guard. Can we go higher? Sure, but the bear clock is ticking.
With the market at all-time highs, you would think the U.S. economy is doing fantastically well. Lance Roberts, editor of the Real Investment Report, pokes holes in that fantasy. According to his analysis, Americans’ household worth has recovered only back to 1995 levels, and only the top 10% have benefited from surging stock prices. Most U.S. families, Roberts says, have been unable to save and invest, primarily because of falling incomes and the rising cost of living.
Obviously, there is a huge disconnect. On one hand, the market has hit all-time highs; on the other hand, most people are struggling to get out of debt and make ends meet.
To be sure, markets can drift higher even on low volume, low momentum, and low volatility. That is why predicting the bull market’s end is nearly impossible. But end it will. Unfortunately, most people learn nothing from history or market cycles.
Roberts warns investors not to ride to the bottom. “Investment returns have likely been pulled forward by central bank liquidity, low interest rates, and passive investing,” he writes. “However, over the next five years returns may be substandard at best, but more likely, negative. At worst, we face an incipient bear market.”
And one day, when most investors least expect it, the correction will begin. Billionaire investor Warren Buffett famously said, “A bull market is like sex. It feels best just before it ends.” For those who have not yet experienced a bear market, they are brutal and last a lot longer than most investors want to believe. Because so many investors think the market will never go down by much, the risks keep rising.
Although it’s tempting to buy the current breakout, cautious traders will sit and wait. Because market volatility is almost non-existent, even on up days, it’s not easy to make money. When the day of reckoning comes, and it always comes, many will lose much of their accumulated gains.
Since the market is an auction, the oldest and best advice is to buy low and sell high. With this mature bull market, the risk-reward is not favorable to those buying at jaw-dropping levels. Other advice: If you are still holding at the highs, be sure to use stop-losses to protect yourself.
The odds are excellent that volatility will return, likely sooner than later (historically, October has been particularly unpredictable). Once volatility appears, astute traders will wake up and prepare for a new order.
Michael Sincere (michaelsincere.com) is the author of “Understanding Options 2E” and “Understanding Stocks 2E.