Market bears may find it fitting that Robinhood is planning its $2 billion IPO later this summer, as the market seems to be topping out.
But the Volatility Index (VIX) has been signaling this pullback for weeks…
Usually when the markets rise, the VIX drops. I talked more about this a couple of weeks ago when I stated:
All-time highs are being made daily.
But over the past two weeks, the Volatility Index (VIX) has been making a material divergence from stock prices.
Normally, as stocks rise the VIX falls, but we haven’t been seeing that lately. Both have been rising, and that’s a reliable sign that the market is due for at least a pullback soon. There are countless examples of this, but in the end, the VIX is always right.
The divergence continued into last Friday until it finally unraveled. And the VIX indicator is still hinting at a deeper pullback from here…
The VIX curve entered a state of backwardation on Monday – that’s when spot index levels are trading higher than the futures.
That’s a signal that the market is worried…
But the VIX hasn’t been the only red flag out there… there’s an even bigger one brewing in the market…
At first it was surprising that this divergence was leading up to earnings season. Historically, buying stocks during earnings has been a winning formula.
And yet with all the stimulus, free money, and more infrastructure spending on the way, earnings growth is set to decline going forward – not rise.
The S&P 500 is estimated to earn around $200 per share over the next 12 months. The average Price-to-Earnings (P/E) multiple for the index since the era of quantitative easing (QE) began in 2009 has been around 18X.
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Currently, we are trading at a 22.5 P/E.
So, either earnings rise around 20% to keep pace with valuation expectations, or we may be set for a good old-fashioned correction. And even if we do… the long-term bull market would still be intact.
Either way, multiples will trade at 18X again at some point.
Right now, earnings are only set to grow 10% into 2023, leaving a 10% shortfall.
And the price action the last few days has been telling us that shortfall will be made up by falling prices, not rising earnings.
All of this comes amid the backdrop of inflation… with more executives talking about price increases – the kind that Jay Powell can’t easily control.
CEOs of major food and beverage companies like Pepsi and Conagra have come out and said that – not only have they never seen this level of price increases – but that they’re going to pass these costs down to the consumer.
For example, Ramon Laguarta, CEO of Pepsi, recently said they’d try to manage rising costs through a combination of higher prices and increased productivity…
That’s just a recent example.
Inflation is being cited as a major cause for concern by more and more executives in their earnings calls…
Unless Jay Powell has a mechanism to stop private U.S. companies from increasing prices even further, it’s hard to see how the U.S. consumer stays resilient.
Since executives are closer to the action, I rely more on what they have to say than the policy makers.
So, when Conagra CEO Sean Connolly says, “This is an atypical level of inflation. It’s the highest inflation level our company has seen in as many years as we can remember,” the word “transitory” loses all meaning.
Right now, the company sees its costs rising at about 9%. Normally it’s about 3%.
Not only have they already raised prices on their products, the “next big wave” of price increases is coming by the end of the quarter.
So with earnings growth set to shrink, the returns from holding stocks are set to be a lot smaller compared to the past 12 months of this bull market.
Aside from the fundamental reasons to expect lower market levels, rampant speculation has created another…
I’m sure investors will be able to rationalize owning stocks at these levels regardless… with the belief that they can simply sell at a profit to the next person. That seems to be the classic thought process when prices only rise… maybe future generations will look at the meme stock frenzy of 2021 the same way we look at the tech bubble that popped 20 years ago.
I expect valuations to compress enough to attract new long-term investors. If what we’ve been seeing the last few days is the start of that process, stocks could easily fall around 10% right to the 200-day moving average.
Since the market discounts the future in real time, the earnings growth from the pandemic recovery seems to have been fully priced in. Most of the market’s gains have historically come when earnings growth is on the rise… not declining as they are now.
A couple of weeks ago, I recommended going to cash or rotating into defensive sectors like XLU. Since then, utilities have been up 0.5%, while both the Nasdaq and S&P 500 are down 2%.
Investors can expect performance to be stacked in a similar way as the markets brace for a correction.
Contributing Editor, Market Minute
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Is the recent sell-off the start of a correction or just a short-term blip?
Do you think inflation is “transitory”? Or do you think it’ll have a lasting impact on most sectors?
Let us know your thoughts – and any questions you have – at [email protected].