The Calm Before the Stock Market Storm

But that trading-range serenity was broken with a vengeance last week as the S&P 500 plunged 2.5% on Friday, rebounded 1.5% Monday, and plunged another 1.5% Tuesday.

So the past eight weeks or so were the calm before the stock market storm … welcome to September!

Market valuations are stretched: The S&P 500 Index is trading at more than 20-times trailing 12-month earnings.

That’s well above the long-term average of about 16 times.

Stock market breadth goes from bad to worse: Less than 30% of S&P 500 stocks are trading above their 50-day price moving average right now, meaning 70% are trending down.

Such a rapid deterioration in market internals is a red flag.

In spite of the recent selloff, investors are still too complacent. The VIX, for instance, is nowhere near oversold levels, indicating rampant fear and a possible bottom.

But there are other risk factors that warrant a cautious outlook on stocks near term. Here’s a big one on my radar …

Wall Street just loves to engineer investment fads and take them to unsustainable extremes.

Portfolio “insurance” in the 1980s … dot-com stocks in the ’90s … and subprime mortgages before the 2008 crisis … are just a few of the fads that ended badly.

Well, the latest fad on Wall Street is something called “risk parity funds” and it’s destined to end badly too.

A risk parity fund is a type of hedge fund that takes highly leveraged bets by going long stocks and U.S. Treasuries at the same time … on super-margin.

In theory, an investor is hedged because oftentimes stock and bond prices move in opposite directions … when stocks slump, bonds rally and vice versa, so you’re hedged.

That’s nice in theory, but the reality is stocks and bonds don’t always move in opposite ways!

These funds have $400 billion in assets, but they routinely leverage anywhere from two- to three-times that amount … for a total investment of over $1 trillion today … and it’s a ticking time bomb.

Why? Because stocks and bonds are moving in the SAME direction recently. In fact, last Friday’s big selloff in stocks was preceded by a bigger selloff in Treasuries on Thursday.

In June, the correlation between stocks and bonds was negative 66% – moving in opposite directions – but today, the correlation has swung to a positive 27%. In other words, moving in lockstep.

So risk parity funds are losing money on both sides of their leveraged long stock-and-bond portfolios at the same time.

Analysts estimate these funds face up to $40 billion in forced selling as a result. That’s more selling pressure than the Brexit debacle, when stocks swooned over 6% in just over two weeks!

So if markets remain vulnerable on the downside, the question is: How low can stocks go?

When markets suffer a mild pullback, they typically give back, or retrace, anywhere from 25%-50% of the previous advance.

A deeper correction can retrace between one-third and two-thirds of the previous rally. The S&P 500 Index chart below highlights these key levels.

Measured from the June 27 post-Brexit low, the S&P is within a stone’s throw of a 25% retracement at the 2,105 level.

Next stop on the downside is near 2,050, in the vicinity of the S&P’s 200-day moving average. This would amount to roughly a one-third retracement of the June-August rally.

It wouldn’t be surprising to witness at least a short-term bounce higher for stocks somewhere in this range between 2,105 and 2,050.

It will be critically important to monitor the magnitude and quality of that bounce.

I’ll be looking for an increase in negative sentiment, a contrary bullish signal that investors are nervous and perhaps throwing in the towel.

Another key signal to watch on any rally attempt is market breadth: Are more stocks advancing on increased volume than are declining in heavy trading?

Finally, a deeper 50% retracement of the rally would bring the S&P 500 all the way back down to the post-Brexit low near 1,990. A correction of that magnitude would be troubling, since it would basically negate all the upside progress made since June, including the recent S&P 500 breakout to new highs.

Bottom line: Not only is September the worst month of the year for stock returns, but the entire period from now up until Election Day is the most volatile time of year (see chart below).

Caution is the watchword. So be sure your seat belts are securely fastened and expect more volatility ahead for stocks, bonds and other markets!

Dutch trick or treat: In a desperate reach for extra yield, a Dutch-based pension fund, one of the largest in Europe, could be on the hook for big losses on a $9.5 billion bet on European corporate loans. What’s the upside? If the loans don’t go bad, the upside for the pension fund is only “double-digit returns” according to Bloomberg.

Political Paralysis: Americans are well aware that our political system is broken, but they can’t put their finger on why it’s broken, let alone what to do about it. That’s the conclusion of a recent study from Harvard Business School, according to Bloomberg. The report goes on to cite American politics as the “single biggest barrier to competitiveness…” and goes on to say the U.S. has entered “an era of political paralysis.” The good news: November elections are just around the corner.

Good investing,

Mike Burnick

Mike Burnick, with 30 years of professional investment experience, is the Executive Director for The Edelson Institute, where he is the editor of Real Wealth Report, Gold Mining Millionaire, and E-Wave Trader. Mike has been a Registered Investment Adviser and portfolio manager responsible for the day-to-day operations of a mutual fund. He also served as Director of Research for Weiss Capital Management, where he assisted with trading and asset-allocation responsibilities for a $5 million ETF portfolio.