What are the signs saying?
Worried about a stock market crash? Are stocks overheated? When will the bubble pop? Suddenly you see your portfolio crashing down as a series of economic events and malinvestments build up and get realized into simple price action. A bubble builds up with hype and euphoria feeding its growth up until the time comes when the bubble bursts and the crash materializes. Despite the burden of a crash, a bunch of professional investors wait for such opportunities to cease above average returns. They have enough discipline and foresight to look ahead and anticipate that after a crash, a perfect timing to buy does exist, giving their portfolio a skewed return on investment.
When the pandemic first hit the world last year, financial markets and most asset classes took a huge hit, triggering a short-lived bear market. The stock market fell by an approximate 20% and a global economic recession followed. However, after the sharp nosedive in March of 2020, the market began a subtle recovery. All indices rose again, euphoria took a seat again, and by December 31, the stock market had regained all its lost ground.
Day Trading might be the main driver of the market in this year’s first quarter; however, market-based fundamentals must not be ignored. What catches the eye is the Shiller price-to-earnings (P/E) ratio for the S&P 500. Historically, going back 150 years, the S&P 500 has averaged a Shiller P/E of 16.78. However now it is much higher at 35.30. Mean reversion trading strategies come into play as current price divergences do reflect a feasible trade with an attractive risk to reward.
Also, market participants should not ignore the ongoing complications of the COVID-19. Much of the news we have received on the coronavirus has been decent, as reflected into financial markets. Many vaccines are now being used to inoculate the population, and millions are being vaccinated every month. However, the virus keeps mutating. Some of the vaccines work well to contain or halt the spread of these variants, but not all variants are the same. The point being that if the vaccination campaign does not occur quickly enough, these variants could show dominance and danger. Many people are choosing not to get the vaccine or are taking a wait-and-see approach. However, for a full recovery, this is not a choice. If too few people receive the vaccine, herd immunity will be pushed further down the road. Professional traders see that the stock market’s incredible 11-month bull run is insane, given the fact that economies across the globe still did not fully recover. This surge in prices may come to a halt, as it does not reflect the real economic well-being. Although traders cannot predict when and how a crash sets up, many indicators are signaling a change in the status quo. Some of which are discussed below.
Rising Treasury yields
The multiyear housing boom could dry up at the blink of an eye. Current homeowners and prospective buyers have been driven by historically low lending rates. Last year, 10-year Treasury yields hit roughly 0.5%, paving the way for historically low mortgage and refinance rates, as well as tempting homeowners to take equity out of their homes. However, the yield curve has been steepening at an incredibly fast pace. Even though rates could rise 100 basis points overnight and still be well below historic averages, homeowners and prospective buyers have been spoiled by historically low lending rates for years. In two instances in the last decade when mortgage rates rose by approximately 100 basis points relatively quickly, new mortgage and refinance applications fell off a cliff. The housing boom has been perceived as a wealth-creating bright spot that is giving homeowners quick access to cheap capital.
The drop in buybacks of equities
The drop in the buyback volume over the past few months will start to show certain outcomes in the near future. In the last two years leading up to the COVID-19 pandemic, the S&P 500 buyback activity hit an all-time high. However, during the peak of the coronavirus recession, bank stocks and a host of brand-name companies announced that they would be reducing or completely holding their buyback activity to conserve cash. Tight risk management on cash outflows became a trend in the pandemic, as economic closures lead most businesses to burn cash as lockdowns loomed in.
Adverse Issues to watch in 2021:
- COVID-19: The coronavirus is not ending anytime soon, and new strains are still emerging.
- Unemployment: Millions of people remain unemployed and will possibly continue to live on stimulus checks and government benefits even after the pandemic gets suppressed. Despite the high unemployment in the U.S, housing prices are surging higher. To professionals, this sounds like a divergence, or maybe another housing crisis.
- Inflation: With increased government spending, markets will probably eye an increase in inflation, which will probably lead to investors pulling back from certain assets.
An optimistic view into 2021:
- Vaccinations: As more people are getting vaccinated, we will see an increase in optimism, movement and spending.
- Existing and New Industries: As world economies fully reopen, corporations will see a continuous rise in value as their stocks again momentum. Also, some industries such as tech, e-commerce and biotech gained tons of ground during the pandemic and will continue to grow and give investors reason to feel confident.
- Low interest rates: The Federal Reserve has promised to keep interest rates near zero, which will encourage spending.
In essence, hype, euphoria and fear are essential elements in forming a cyclical market. Financial markets should go through ups and downs, and many crashes have occurred. However, historical data shows that recoveries are always around the corner. You can day trade and try to ride the waves on a short-term basis trying to catch pips and cents from every tick, but as a rational investor, you should always rely on both fundamental and technical analysis. Nowadays any news or any change in market environment, whether it was pharmaceuticals, e-commerce, tech, or finance, is triggering a massive change in market dynamics. Many signals indicate that markets will crash, but history shows that with time, resilience always rules, and traders must be disciplined enough to take advantage of opportunities. To become a professional, look for the signs, study the inside of the market, analyze the fundamentals as well as the technicals, do not get carried away by the hoard, and master your own trading strategy.
This article was submitted by Royal.