starfox2000

SPX broadening formation and some history

FRED:DGS5   5-Year Treasury Constant Maturity Rate
Since 2018 the S&P500 is caught in a broadening formation, usually not a bullish sign. Yet the market keeps rising and is currently at the top of the formation.

As can be seen the Shiller P/E (teal lines) was initially decreasing a bit, but is now back to where it was three years ago and matches the S&P nicely in more recent times, indicating that recent price changes are mostly due to multiple expansion and not better earnings .

The time period with the best comparable broadening formation I could find are the 70s. The market was at a (then) relatively high P/E of 24 when it started entering the broadening formation. It was the time of Nixon and the Vietnam war.

A couple things are worth noting:
  • The time period back then was much longer. The market was trapped in the broadening formation for 12 years, give or take, we are now embarking on our third year.
  • The P/E ratio was decreasing initially, but on the first two bounces it again increased with the market, only to go down again. It wasn't until the third bounce that the P/E ratio stayed low, sank even for years, but the market went up, meaning that earnings improved dramatically. In 1982, when the P/E ratio hit 7, the market started a 18-year (let's forget about 1987/1990) dramatic bull run and never looked back.
  • The explanation for this phenomenon is that Inflation (green line) was much much higher and far above bond yields (blue), reaching 10% at times. As is obvious from the chart, inflation is not automatically great for stocks, in fact they traded sideways for a long time and it soured investors' appetite for stocks when the multiple deflated from 23 to 7. But it got rid of a lot of debt and set us up for the bull market in stocks and the even longer one in bonds later.


Enough history, how do I trade this?

No one was shorting into this market for the past couple of months because it was suicide.
First of all you could have the idea of betting on stocks bouncing right off the upper bound of the formation. And you would be in good company, the internet is full of articles about the smart money being short now.

Are earnings going to improve? Or will bankruptcies and the fallout from the economic damage finally fully show, now that government support programs expired? I'll leave that up to you, but one more small stimulus package is due, which I suspect will give us a short rally, but will ultimately fizzle.

That leaves multiple expansion, which could of course increase indefinitely. But it is on the same level as at the peak in 1929 and it's only really been higher once, during the New Economy bubble when it reached 44.


What about inflation? Will it send stocks soaring? Crashing? Set us up for a huge bull market?
The latest inflation expectations from the Fed are abysmal and despite AIT and whatnot it does not look like it will arrive anytime soon, so I wouldn't worry about that right now.

Even though it's bad the economic situation is probably not dire enough that they would unleash high inflation now when the dollar as reserve currency is perceived as being under threat and buyers of (the humongous) US debt issuance are anxious as it is.

RSI has maybe another two months to hit its downtrend line, assuming it reaches it at all, but Trump would be markedly unhappy if the market went down right before the election, probably doing his best to avoid that. So I would bet on a correction either happening in September, historically often a terrible month for stocks, or after the election, possibly even in 2021. The past 10 years have taught me that freshly printed money can inflate multiples for a long long time, which is why my preferred option right now is observe, but if I come across some ridiculously cheap puts or VIX calls, I will bite.