Don’t look now but the trend that was established back when the first vaccine was announced seems to be in jeopardy.
The S&P 500 has been marching its way toward 4000 for weeks now. Of course, this is nothing terribly remarkable in and of itself. Given enough time, the probability of the S&P 500 reaching (and surpassing) 4000 is extremely high. The question is less “if” than “when”.
The original trend was climbing on a pace of approximately a 31 PE for the index. This is a historically high multiple that has been rationalized primarily by historically low interest rates. (Because that risk-free rate of return is so low it throws off other math.)
Looking at last week, the SPX posted its all-time high on Monday then faded sideways over the rest of the week. (Not all the major indexes failed, which is part of why the trend is not ‘dead’ per se, just in danger.)
Looking at the futures for Monday, looks poised to open lower.
The question is, will there be traction? Do markets find buyers here and move higher, or will behavior change?
While the government tracking methods insist inflation is a ways off, more anecdotal measures (like the cost of gas at the pump or groceries in the store) tell a different story. Interrupted supply chains, political red tape, and yes – Covid restrictions – continue to play a significant role in this saga.
A look at the financial sector implies that rates may be rising soon.
If all of this is true, interest rates would risk, multiples would decline, and indexes would likely decline in response.
The wild card is stimulus. It’s really an inflationary tool. The issue is, in the short-term, it changes buying behavior by stimulating the demand side of the curve first. People can literally buy more stuff, so they can drive prices (and profits) higher in the short-term. But longer-term, it changes the supply of money in circulation, reducing its purchasing power. The creates all kinds of knock-on effects in valuation formulas (especially in lending).
The market seems to be digesting all of this now. It would not be surprising if the PE ratio of the S&P 500 began to decline toward more historic norms. Likely it will still remain higher than long-term averages, just not as high as it’s been.
Does this imply a major correction in the markets?
If corporate earnings continue to climb – which they very well may, given the probability of stimulus driving demand – earnings could climb while PE ratios decline. In affect, we could see a sort of sideways market where both variables more or less cancel each other out.
If this is the case, the 4000 level could become a bit of a plateau for a while as the index oscillates around it for an earnings season or two while markets figure out where things are going.
Think it sounds crazy? Go look at some of the major real estate markets around the country. Pricing in many areas is at a point where cap ratings are nearing parity with treasuries. It’s almost as if risk-free rate of return is no longer part of the equation.
History, of course, teaches us that markets can remain irrational for longer than expected (and certainly longer than you can remain solvent). So it’s not to suggest prices can’t go higher. It’s to suggest prices are very expensive in certain areas of the market if we see interest rates rise.
And that’s really the key: this market is now built on low interest rates. Any change to this would create systemic shockwaves.
The Fed has more or less opened its playbook up and is telling everyone the calls before they make them. “Rates will stay low” is basically the message. But if for any reason this story changes, things could get interesting quickly.
For this week, the question is whether or not the market resumes the 30-ish PE climb, or if there is more shake-down to come after last week’s sideway move.
The technical patterns have largely been organized and moving higher. However, the next big fat round number (4000) is about here, and that typically means there’s some oscillation as markets evaluate bigger picture metrics.
Also, we’re in the middle of earnings season right now. That will quickly taper off and we’ll begin to look toward Q2 for the next trend confirmation.
On the upside, resistance is likely at the 4000 level, with some intermediate resistance at 3975/3986.
On the downside, support is likely around 3872. If that fails, look for 3858, and an extreme downside of 3812.
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