Caution flag comes out as U.S. stock market reaches new records


Attention, investors: It’s time for caution in the stock market.

Five big challenges have cropped up in the past two weeks. They’re telling us the market will struggle to move higher, and it may even drop sharply in the seasonally volatile months of September and October.

Below, I’ll give you an easy five-point plan for positioning your stock portfolio to help you navigate this new market environment, and get prepared mentally.

But first, here are five ominous challenges stocks face.

Market challenge No. 1: Investor sentiment is getting rich

From a contrarian perspective, this is troubling. Whenever a lot of people are bullish, it’s a sign that most of the good news is already priced in. And there are fewer people with money on hand to push your stocks higher.

I track a dozen sentiment indicators, and currently six are bearish, one is bullish and the rest are neutral. This isn’t “kiss of death” bullishness, but it is a warning sign, especially combined with the four challenges below.

A great example of the current bullishness gripping the market: The demand for put options relative to calls is the lowest it’s been in more than a decade, according to the Chicago Board Options Exchange data. Put options are a bet stocks will decline, and investors buy calls when they think stocks will go up.

Next, the percentage of bullish stock letter writers jumped to 59.5% last week, according to Investors Intelligence, the highest level since January 2020 (59.4%). I also track the Investors Intelligence Bull/Bear ratio. This has risen to 3.60, which puts it near the warning path. In my system of reading this indicator, anything above 4 is a clear sign that sentiment is getting too rich. (In contrast, below 1 signals that stocks are a strong buy. This ratio was at 0.72 in the last week of March during the Covid-19 market meltdown.)

It’s also notable that the number of investors short-selling stocks, a bet they will fall, is declining.

Market challenge No. 2: Insiders are on vacation, and not because it’s August

The ratio of stock purchases to sales by in-the-know executives and directors tell us market insiders don’t care much for their own stocks. This ratio is slightly bearish, according to Vickers Insider Weekly.

A more nuanced analysis of insider activity I regularly do for my stock letter shows a somewhat darker view. Not only has insider buying dried up, but it has all but vanished in cyclical names including industrials, materials and banks.

This tells us insiders no longer think cyclical stocks are cheap, relative to their prospects. Because insiders regularly see real-time economic updates via internal performance numbers, their buying patterns tell us how stocks are priced relative to the economic outlook. Today, cyclicals are not priced attractively, say insiders.

Market challenge No. 3: Stock valuations are stretched

To be clear, insiders aren’t necessarily predicting sharp economic weakness. I’m not, either. The Atlanta Fed’s GDPNow tracker recently put annualized third-quarter GDP growth at an amazing 25.6%. The Citigroup Economic Surprise Index is at or near record-high territory. The housing market is strong, and it has a big impact on the entire economy.

It’s just that all this potential growth seems priced in. And insiders are telling us they know it — by taking a break from buying their own stock.

The forward price-to-earnings ratio on the S&P 500 Index
SPX,
+0.16%

hit 22.3 on Aug. 21, up from 12.9 on March 23, points out Ed Yardeni, of Yardeni Research. That’s the highest it has been in the past 15 years. And it is well above the 15-19 range where it traded in the past five years. Yardeni predicts the V-shaped recovery in the U.S. will continue through September, and then slow to more of a Nike swoosh.

Market challenge No. 4: Participation in the rally is dwindling

As the S&P 500 and the Nasdaq
COMP,
+0.08%

hit new record highs last week, fewer and fewer stocks participated in the strength. This is often a sign the strength will not continue.

Inside the S&P 500 on Aug. 21, around 200 stocks were up, and almost 300 were down. On the New York Stock Exchange, twice as many stocks were down than up. Driving the indices higher were the usual suspects: Facebook
FB,
-0.68%
,
Apple
AAPL,
-0.33%
,
Amazon.com
AMZN,
-0.19%

and Alphabet
GOOG,
+0.17%

GOOGL,
+0.25%
.

To put this another way, if a lot of stocks are performing poorly underneath the narrower indices tracked by the media, it’s a way of saying a “stealth” correction has already begun. But it just hasn’t been picked up by the market “bugs” in the corner of the CNBC screen, which can keep enthusiasm afloat among the crowd and superficial…



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