Technically Speaking: S&P 500 – Trading At Historical Extremes

Welcome to 2021. As we kick off a new year, we begin with the S&P 500 trading at historical extremes. It is essential to have some perspective to set reasonable expectations for future returns and quantify the “risk” of something going wrong.

As we discussed with our RIAPRO.NET subscribers yesterday, the real risk to the market in 2021 is over-confidence.

“Currently, Wall Street analysts are wildly exuberant on expectations of explosive economic growth, rising interest rates, and inflation. The problem with those expectations is that in an economy that is $85 Trillion in debt, higher rates and inflation are a ‘death knell’ to economic growth.

Yes, while the Fed may come to the rescue with more QE, with markets already trading at 36x times earnings it is becoming increasingly difficult to justify overpaying for earnings. Eventually, corporate earnings are going to have to markedly improve, or prices will revert.”

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S&P 500 Trading Extremes, Technically Speaking: S&P 500 – Trading At Historical Extremes

There is a high long-term correlation between the index and earnings of 88%. As shown, extreme deviations from the long-term correlation have always preceded short- to intermediate-term corrections.

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S&P 500 Trading Extremes, Technically Speaking: S&P 500 – Trading At Historical Extremes

Short-Term It’s A Coin Toss

In the short-term, which equates from a few days to a few weeks, markets are sentiment-driven. As we showed in “2020-A Year Of Speculative Mania,” investor sentiment is just about as “bullish” as it can get.

“The chart below shows the combined average of institutional and individual investor valuation confidence subtracted from future returns confidence. When the reading is positive, the confidence the market will be higher one year from now is more elevated than the confidence in the market’s valuation.  The opposite is the case when the reading is in negative territory.

The key takeaway is that investors think simultaneously, the market is over-valued but likely to keep climbing.” 

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S&P 500 Trading Extremes, Technically Speaking: S&P 500 – Trading At Historical Extremes

“Such is the same phenomenon famously described by former Fed Chair Alan Greenspan in a December 1996 speech on ‘Irrational Exuberance.'”

However, it is that “sentiment,” or more commonly known as the “Fear of Missing Out,” that can continue to drive prices higher in the short-term.

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