Strange Things Are Happening to the Stock Market

Be prepared for prices and sentiment to roll over

By Michael Sincere, MarketWatch

I’m looking forward to the second season of “Stranger Things,” the excellent Netflix science fiction series about a group of children from Indiana who encounter some odd occurrences in their hometown in 1983.

I can’t help but notice there are strange things happening to the stock market as well, with the U.S. market at all-time highs. Consider:

1. The price/earnings ratio (p/e) of the Russell 2000 RUT, +0.55%   is approximately 237. For perspective, the Nasdaq Composite COMP, +0.37%  had just reached 5,000 on March 9, 2000, and its p/e was at 175. At that time, one well-known analyst famously said that “P/E’s don’t matter anymore.” Days after the Nasdaq hit 5,000, the market began to plunge…until it had fallen by 75%.
2. The cyclically adjusted p/e (CAPE), a measure created by economist Robert Shiller, “now stands over 27 and has been exceeded only in the 1929 mania, the 2000 tech mania, and the 2007 housing and stock bubble,” says Alan Newman in his Stock Market Crosscurrent letter (source: CNBC).
3. Investor sentiment is going from one extreme to the other. As bullish investors cheer for Dow 20,000, don’t forget that in 2012, the crowd chanted for gold to go to $5,000 an ounce when it was near $2,000. Now gold is near $1,100 an ounce, and few are cheering. In 2014, the crowd chanted for oil to go to $150 a barrel when it was at $110. After the oil bubble burst, oil is sitting near $50 a barrel.
4. Sentiment indicators such as the RSI, and sentiment surveys including the AAII (American Association of Individual Investors) and Investors Intelligence reflect the belief that stocks are not going down, and if they do, will bounce right back. Few investors are expecting a pullback, or even a correction, especially as the year comes to a close. These beliefs always happens when the market is near extremes, and just like in 1999, most believe the market will keep going up. The only fear from investors is the fear of missing the next rally.

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Although an irrational market bubble is forming, it can get more irrational before it eventually pops. Mark Cook, coauthor of the book, “Prepare Now and Survive the Coming Bear Market,” says that “the most definitive environmental characteristic of a bubble is sentiment. A market that has no fear is the most vulnerable of all. We are one of the few who believe that 2017 will have a 20% or greater correction. It is not only a minority opinion but almost non-existent probability in the minds of the general public.”

Cook says that he is certain we are in a market bubble. He says that if you are a trader, however, consider a bubble as an opportunity, not a calamity. It is not easy to navigate, but if you can, it can be very profitable.

Bubble strategies

As the market moves from extremely overvalued to ridiculously overvalued, it is dangerous to short this market (at least until after there is a severe break), but buying at these levels is also risky. It’s true that if the Dow Jones Industrial Average DJIA is able to surpass 20,000 before year-end and stay there, the Dow could go higher. Then we would get even closer to the infamous “blow-off” top so many technicians write about. That’s when the panic buying really ramps up as anyone left behind buys anything that moves.

Eventually, bubbles implode in a number of ways. They can pop and crash in dramatic fashion, or deflate slowly as no new buyers enter the market. Eventually, the market is so exhausted it has to roll over.

It’s a huge mistake to believe the market will go up indefinitely. It’s also a mistake to sell everything in a panic because you believe the market will crash. Instead of panicking, create a plan of what you will do if the market rallies, plunges, or goes sideways.

No one knows, of course, how this irrational market will react to major political and economic changes. All you can do is prepare for any outcome, no matter how strange. The only guarantee is there will be a major correction sometime in the future, but no one can say when. It could be next week or month, or longer. Although the sentiment indicators suggest the market is close to topping out, wait for a major break in the market before taking action.

Michael Sincere is the author of “Understanding Options 2E” and “Understanding Stocks 2E.”

Courtesy of MarketWatch