Connecting the Dots: Correction? What Correction?

The textbook definition of a correction is a drop of 10% or more. The stock market came close to hitting that correction benchmark and has mounted a furious rally since mid-October. The S&P 500 has staged a remarkable rally, jumping by 12% from its October lows in just four weeks.There’s something in our DNA that pushes humans to follow the herd, and investors have been herding into the stock market in almost unprecedented enthusiasm. I mean really herd.

Get this: the S&P 500 has closed above its five-day moving average for 20 consecutive days. A five-day moving average is an extremely short-term indicator that can rapidly change, so the feat of staying above this hypersensitive indicator for almost a month is rare.

How rare? It has happened just three times before in the last two decades.

And each time when the market rallied so vigorously, the winning streak ended within four weeks. That tells me that despite the stock market’s hot hand, the risk/reward profile of the stock market is in favor of the downside.

The rally has also pushed valuations back into nosebleed territory. The S&P 500 is now trading at a P/E ratio of 19, which is well above the historical average of 15.

The stock market looks even more overvalued if you dig a little deeper. The Shiller P/E ratio, developed by Nobel Prize-winning economist Robert Shiller, adjusts earnings for inflation and average corporate earnings over the last 10 years. The current Shiller P/E ratio is 26.5, dangerously high compared to the historical average of 16.

Could the stock market get even more overvalued? Sure! During the dot-com heydays, the Shiller P/E got as high as 44.

Perhaps you’re not impressed with Shiller’s work. How do you feel about Warren Buffett? Buffett’s favorite valuation indicator is the total stock market cap divided by GDP.

Buffett called this indicator “the best single measure of where valuations stand at any given moment” because it really compares the relationship between the stock market and the economy. In short, when the overall market capitalization is greater than GDP, the stock market is expensive.

Like the Shiller P/E ratio, this market cap/GDP ratio is dangerously high at 127% of GDP, which is its highest reading since the dot-com days.

Last, the current rally is starting to show cracks in confidence. In strong, healthy, long-lasting rallies, the stock swings tend to narrow. When investors are confident, volatility tends to narrow, which is exactly what we saw over the last two years.

Volatility has increased, and the S&P 500 is now showing what’s called a “broadening top,” a trading pattern that shows a wider trading range.

Think of it as like political election polls. A candidate with a solid lead tends to see his pre-election poll numbers remain steady, if not increasing. If the pre-election polls started to show a narrowing margin of victory in the last weeks before the election, an upset may be in the cards.

Investors are becoming more uncertain, and the bears have narrowed the advantage to the point that a stock market upset seems more likely.

Many, if not most, investors have been conditioned to “buy the dips,” and that has been the right move since the 2008 financial crisis. However, I like to pay more attention to what’s ahead of me instead of what’s behind me; and we’re moving into a new era of post-QE where “selling the rallies” will be the new, right move.30-year market expert Tony Sagami leads the Yield Shark and Rational Bear advisories at Mauldin Economics. To learn more about Yield Shark and how it helps you maximize dividend income, click here. To learn more about Rational Bear and how you can use it to benefit from falling stocks and sectors, click here.