The stock market is rebounding from the huge sell-offs earlier in 2018, and second-quarter economic growth is strong. However, you should not increase your investments in stocks or buy stocks on margin. While no one can predict market movements, below are five reasons why we believe risks are higher today.
Excessive optimism – Bullish Market
In a bullish market, most investors are hesitant towards purchasing stocks. Bad news is also more likely to trigger sell-offs. Not all measures of market sentiment agree, so we are not at extremes yet—but we are approaching.
Let’s look at the Ned Davis Research Crowd Sentiment Poll and Daily Trading Sentiment Composite, for instance. According to both, optimism is excessive or extreme. Sure, the economy benefits from the skyrocketing consumer optimism—close to its highest in a decade—but such levels of optimism often indicate stock market corrections.
Poor market internals
High sentiment by itself doesn’t foreshadow a market correction. It’s a much stronger indicator, however, once we combine it with market internals. According to Bruce Bittles, a market technician and chief investment strategist at Baird, fewer stocks are participating in the booming main indexes (S&P 500, Dow Jones, Nasdaq). “Under the surface, the broad market continues to lag the averages,” he says. In other words, the rising stock prices averages are increasingly dependent on a decreasing list of stocks.
In late July, the Nasdaq hit new highs, but only about 50% of its stocks traded higher than their 200-day moving averages. The S&P 500 soared as well, the number of rising stocks was equal to the number of falling stocks.
So, while the headlines speak of booming stocks, market breadth is too narrow to support such headlines.
Vicious sell-offs may be on the way
Historically, the market experiences significant sell-offs in September and October, thus those months usually produce the smallest gains. This is typically even worse during election years. According to Bittles, the weakest part of the presidential election cycle is the months before the mid-term elections. Note that the seasonal weakness is often tougher on small-cap stocks.
Typical valuation measures are inflated
While valuation measures aren’t great tools for timing the market, they can show us a lot about the odds of market movements. With today’s high valuations, there is only room for limited upside.
Protectionism means more fear and uncertainty
Ultimately, trade wars, tariffs, and protectionism are bad for economic growth—in fact, economic historians blame such measures for extending the Great Depression during the 1930s
Of course, this is old news for investors, so the stock market drops whenever Trump even hints at new protectionist measures. Just a few days ago, the White House announced that it is considering more than doubling its proposed tariffs on $200 billion of Chinese goods to 25%.
Bob Doll, the chief equity strategist at Nuveen Asset Management says that the prospects for an all-out 1930s-style trade war remain low. Whether he is right or wrong might not matter in the short term. It seems that the current US administration strategy is to use threats to spread fear and uncertainty in an attempt to soften up the other side before the threats are withdrawn to make a deal. Therefore, the tariffs might only increase slightly—as Doll suggests—but the fear and uncertainty will still impact the stock market.