I am normally not a big fan of doing market commentary, since most of the time the reasons given for the action are not really true, but just make a good story. Supply and demand for shares move prices, and the reasons behind the big institutional volume are often not known to anyone in the financial press. However, today I am not going to attempt to give the reasons behind what it is happening, but rather examine what are the possible routes the market could take from here and what strategies make most sense given these possibilities.
We have seen a reversal from the steep sell-off that ended July and the initial follow through that followed in the beginning of August. Now we are back up sitting just below the all-time high for the Dow. You can see from the chart that we are sitting right underneath resistance and are forming a base here.
As a trader, this is the kind of set-up we used to like to see. At some point soon, the markets will either make a new record high and follow through or test the previous high and fail. Either way, it is likely that volatility will expand in the coming months. We had a nice slow and steady uptrend since mid-February, and we will see if the markets can hold onto that trajectory.
However this examination all falls under technical analysis, and if you are not speculating you should view the current level as a danger zone. Most market participants pay very little attention to the Dow because it is very vulnerable to the performance of just a few companies. The S&P500 is the most widely followed index in the US since it represents a much wider view of what is going on in the market as a whole, but even better is the Russel 2000 index, which is comprised 2,000 companies and therefore most likely to be representative of the market as a whole.
This might not seem like a big distinction until you dig into the numbers, the most important of which to evaluate when trying to determine if a market is valued correctly being the price to earnings ratio, which I have written about many times in the past. At first glance, the market may appear to be not too bad if you look just at the Dow Jones Industrials, which are trading at a P/E of 16. Not exactly value buy territory but not too overblown either.
The trouble starts when you dig deeper into the broader market. The S&P 500 is trading at just under 20, and even worse the dividend yield of less than 2 percent does not make a very good argument towards buying into the index at these levels to produce an income stream. This index is still hovering around the levels that traditionally have been a good sell signal.
The Russel 2000, now get this, is trading at a whopping 79 times the combined annual earnings of the underlying companies. Value? If there is a reason in the world to pay 79 times the annual profits of a company than that reason has never been explained to me other than in terms of what is known as “the greater fool theory”. This states that it can still be a good buy at these levels simply because there will be bigger idiots than you that come along and keep buying and thus forcing the price up to even less realistic valuation levels.
Even worse from a technical standpoint is the divergence between the Russel and the Dow. If you notice the Russel has not made the same pattern and traded back up to just under its previous high. This divergence is a classical sign of a possible overall trend change in the market. I am not saying it won’t follow through to the upside from here, but I surely would not be buying into the market at these levels. If I was still trading, I would be looking for a safe place to go short if we fail on the next attempt to push through to new highs. If you are already in the markets, I would seriously consider taking some profits off of the table and banking them away for a buying opportunity during the next crash.
David Mayes MBA provides wealth management services to expatriates throughout Southeast Asia, focusing on UK Pension Transfers. He can be reached at david.m@faramond.com. Faramond UK is regulated by the FCA and provides advice on pensions and taxation.
