The sharp gains in stock prices so far this year coupled with continued low volatility are making some market strategists nervous. Despite low inflation and stable growth, an increasing number are urging caution.
They admit that the rally could continue for a while if earnings continue to improve and bond yields remain low, but the fact remains that the current bull market in stocks has entered its ninth year.
In addition, the economy is expected to continue its moderate growth of around 2% a year, despite the 2.6% annualized growth rate reported in the initial reading for second-quarter GDP growth, and interest rates are more likely to rise than fall much from current levels given Federal Reserve policy to hike short-term rates at least once more this year and to begin unloading its quantitative easing purchases in an effort to reduce its balance sheet.
Raymond James' models “suggest this static period is ending with a downside attempt due," writes Jeffrey Saut, the firm's chief investment strategist, in a recent market commentary. "Given that potential, our advice (unlike our advice since April) is to not buy into the first dip if it does indeed happen.”
Sam Stovall, chief investment strategist of U.S. equity strategy at CFRA, writes, "The S&P 500 is entering into a historically challenging two-month stretch and the market is long overdue for a decline of 5%+." But he adds that "since we see no recession on the horizon, however, a decline should not lead to devastation."
Prices Have Risen Too High Too Fast
Stocks have been climing to records highs at an unprecedented speed. The Dow Jones industrial average has set three thousand-point milestones in a calendar year for the first time, and it broke above 20,000, then 22,000 in a matter of months. Those last two moves were “big jumps in a short time,” writes Brad McMillan, chief investment officer at the Commonwealth Financial Network. In contrast, he notes, it “took years of basebuilding” for the two previous big breaks — through 14,000 and 18,000.
Previous climbs to milestones in 2006-2007 and 1998-2000 that followed extended periods of flat markets, similar to 2015 and much of 2016, and had little pullback afterward led to massive price declines. The stock market didn’t recover for years.
“Right now with confidence high, with earnings doing very well and much better than expected and with market psychology bullish and likely to get more so, more gains in the market are quite likely,” writes McMillan. “At the same time, you could have said the same … in 2006 and 1999.”
Volatility Remains Extremely Low
Despite major stock indexes hitting record highs this year, the VIX index, which measures volatility in the S&P 500, has been trading between roughly 10% and 16%, below its long-term average near 20%, and closed closed Friday at 10.03%, down 29% year to date.
Such periods of low volatility coupled with strong returns tend to be followed by periods of high volatility and low returns as volatility reverts to the mean, writes Mitch Zacks, a portfolio manager at Zacks Investment Management.
“When markets are calm for too long risks have a tendency to build up in the system without many people noticing, which sets the stage for sometimes massive market dislocations, as they did during the tech bubble in the late 1990s.”
The current low volatility measure is a warning sign for investors albeit not an “outright flashing red” one if forward earnings approach double digits for the year, writes Zacks. He’s especially concerned about low volatility in technology stocks — lower than utilities — which “stinks of complacency building up in the technology sector.”
Tech Accounts for a Sizable Portion of the Run-up
Five tech stocks are responsible for about 25% of the stock market rally this year: Facebook, Apple, Amazon, Netflix and Alphabet, the parent company of Google, also known as the FAANG stocks. Except for Google, which is up just over 20%, the rest have gained more than 30% year to date, including Facebook and Netflix, which have each soared over 45% through the close on Friday. The market capitalization of all except Netflix is near or above $500 billion.
A surge in Apple shares last Wednesday sent the Dow above 22,000 for the first time, the latest milestone. Apple, with a market value of $804 billion, accounts for about 4% of the S&P 500’s capitalization. The latest rally in Apple shares led CFRA to downgrade the stock from a strong buy to a buy due to a “more muted upside to our analyst’s 12-month target price of $175." Shares ended Friday at $156.39.
Large-cap funds and ETFs are especially vulnerable if the tech sector, and especially Apple, falters. Portfolio managers have set a record overweight in tech, according to Bank of America Merill Lynch. In addition, 129 ETFs own Apple as one of their top 10 holdings, according to Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. Shifting valuation assessment of Apple “could impact a wide range of ETFs, including PowerShares QQQ (QQQ), SPDR S&P 500 (SPY), Tehcnology Select Sector SPDR (XLK) and iShares Russell 1000 Growth (IWF).
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