Investing

4 Signs That the Stock Market Might Be Peaking Out

The stock market all over the world keeps going up. But will it continue? We discuss 4 troubling signs that point to possibilities of the market reversing its course.

The global stock market has been on fire in the past year. Most of the major indices around the world like the S&P 500, Hang Seng Index and Nikkei 225 have all gained 10% in the past 12 months, and even normally "boring" markets like Korea and Singapore have gained significantly since 2016. But, there are signs in the economy that may suggest that this bullish run may not have much juice left in it. Here, we discuss 4 signs that investors around the world should heed before putting more money into the stock market.

We're About 1 Month Away from the Longest Bull Market in History

In August of this year, the S&P 500 will have had its longest bullish run in its history. After hitting bottom on March 9th of 2009, the stock market has soared over 300% for 113 months. Now, it is only about 1 month shorter than the longest bull market in history that lasted from October 1990 to March of 2000. If this trend continues, this market could set a new record in March of 2019 to reach its 10th year anniversary, which no other bull market has ever achieved. Sure, there is always a chance that this time may be different and that the stock market continues to rise for longer. However, this should be the first sign that investors heed before putting more money into the market.

The longest bull market in history was 114 months so far.

Peak Speculative Activities through Margin Financing

Another sign that suggests that the market might be peaking is the level of speculative activities that are occuring. For example, margin lending, through which investors borrow money to earn higher returns while taking on more risks, has reached its highest level ever by a big margin. FINRA reports that there are now $668,940 million of margin loan that has been lent in the US as of May 2018. To put this in perspective, this is 61% higher than what it was at the peak of the last bubble in 2007 and 123% higher than what it was at its peak during the tech bubble in 2000. Even as a % of total market capitalization, margin lending is at its highest level of 2.9%. Ultimately, investors' willingness to borrow to buy stock is a representation of their willingness to ignore risk to chase returns; in this sense, greed and market speculation seem to be quite prevalent while fear seems to be quite rare.

Debit Balances in Margin Accounts in the US

Debit balance in margin accounts has reached $670bn in the US

Valuation Is Near Peak Despite Slower Growth

Thirdly, the market valuation is nearing its peak. Currently, the S&P 500 is trading roughly around 25x PE ratio based on trailing 12 month earnings. While the S&P 500's PE ratio has been above 100x at points due to the fact that economic recessions collapsed in its earnings, the current level of 25x actually represents a quite high level compared to other pre-crisis peaks in the past few decades. For example, the S&P 500 was trading at 20x trailing earnings in 2007 at its peak, while it was trading at 28x in March of 2000 before it began its descent.

The S&P 500's PE Ratio is near its peak levels priot to market crashes in the past

Another reason why this level of market valuation is worrying is that overall economic growth has slowed down considerably despite massive technological advancements we've seen in the past decade. For example, the US economy (which is about 25% of the world economy) is now growing at 2.3% in 2017 compared to 4.1% in 2000 (and 2.7% in 2006). Even China's growth has slowed from 8.4% in 2000 and 12.7% in 2006 to 6.8% in 2017. The fact that investors are paying similar price for lower growth compared to other market bubbles is a troubling sign for things to come.

Unemployment at Historical Low

Below is a graph from US Federal Reserve charting unemployment rate against the 3-month Treasury rate, where greyed out areas represent recessions. As you can see, bottoming unemployment rate and rising interest rate have generally led to an economic recession for the past 50 years. Not only that, we are precisely at the moment when unemployment rate is nearing its historical low all the while interest rates have been rising quite rapidly.

Unemployment rate in the US is nearing its lowest levels while interest rates are rising rapidly
Source: Federal Reserve Bank of St. Louis

This could be a troubling sign for the markets for two reasons. First, with unemployment rates being so low, there is very little upside for the economy to improve from here. Second, consumers have been levering up their balance sheets again, but this time with consumer loans like credit card debt, auto loans and student loans. These loans tend to be much more sensitive to short-term rate changes, implying that consumers could see meaningfully reduced spending power as their loan service payments increase rapidly along with the interest rate.

What Could You Do?

If these signs don't worry you and you continue to believe that the market has plenty of upside, you can go ahead and continue investing in the stock market. Even so, it's still advisable to build a well diversified portfolio that is relatively less sensitive to the market fluctuations. However, if these signs do worry you, there are a few alternatives that you can consider owning to diversify your portfolio outside of equities.

First, conserving cash is not a bad way to weather the storm. Warren Buffett advises to be "fearful when others are greedy and greedy when others are fearful." In order to do so, you need to preserve cash when the market is greedy so that you have some dry powder to that you can use to be greedy when the market begins to crack. It could be even better to earn some yield on very liquid assets while waiting for the market crash, but cash is still the simplest and most liquid asset you can have.

Otherwise, the key would be to look for alternative investments that are uncorrelated with the stock market. For example, gold has traditionally served as an alternative asset that tended serve as a hedge against a market collapse. Also, crowdfunding investment platforms have risen more recently to provide retail investors with an opportunity to invest in small business loans; while this could still be influenced with the economy, it is still less correlated to the stock market.

Duckju Kang

Duckju is the Senior Vice President of ValuePenguin Singapore. He covers the financial services industry, consumer finance products, budgeting, and investing. He previously worked in the financial services industry, including at such hedge funds as Tiger Asia and Cadian Capital.