Is the US crash coming NOW? (Updated: 12/8/17)

As we come into the most bearish months of the year-- August and September, I thought it's crucial to make a very simple and brief update on the current economy state of the U.S. to see if these two months would finally be 'INI KALILAH'. For this purpose, I'm using Sam Stovall's Sector Rotation approach and looking at a few pair of the spreads, the Dow Theory, the Gold price. Finally, I'll also be examining the fundamental of the SP500 by looking at its PE ratio.

Sector Rotation

Sam Stovall's approach is using 4 economic sentiments (Bond yields, interest rates, industrial production, and consumer sentiment) to anticipate the direction of the economy 6 months to 1 year in advance.

As I judge them, the Consumer Expectations is DECLINING, Industrial Production is RISING and seem to be FLATTENING, Interest Rate is RISING RAPIDLY, and Yield Curve is still considered as STEEP but has signs of FLATTENING as compared with the yield curve at the start of 2017. I'd conclude that the US economy is in a stage of FULL RECOVERY. As investors bet in the market based on their expectation, the market cycle will often precede the economic cycle. Thus, it's safely to anticipate that the market is already at a potential top and it will adjust accordingly as the economy continues to show strength.

Spreads

1. 10-year Treasury Yield vs. Fed Funds Rate

The spread between 10-year Treasury Yield and FFR usually tightens before any major crash, especially when the 10-year Treasury Yield has fallen below FFR.

From the picture above, it might give us an illusion that the spread is still doing good-- not really tightening yet. But wait till you see the big picture:

The shaded areas indicate US recession period. As we can see, the 10-year treasury yield falls below FFR without exception within the period shown, and if the FFR stalled and is above 10-year treasury yield, it's time to watch out for the bear market that happened earlier than the shaded area above (why? because again, the market cycle often precedes the economic cycle). This phenomenon is obvious during the previous 2 recessions. Thus, I'd be closely watching the hints from the Fed-- if the Fed signals peak of interest rate and it is already above the 10-year treasury yield, then I'll stay very very cautious for the potential market top. But is it already happening now? It's obvious it's not. But still, will there be an exception this time? I wish I know.

2. 10-year vs. 3-month Treasury yield AND 10-year vs. 2-year Treasury yield

When the spread dips below 0%, it shows big trouble is brewing and it's time to watch out in the stock market. Obviously, the spread hasn't dipped below zero but it looks like it's on its way. The downtrend of the spread signals that the economy of the US is showing weakness, but the bear market is potentially not here yet.

Looking at another pair of famous spread, it is also showing sign of weakness, but not yet dipped below 0% that warrants very alarming stock market level and economy state.

Shiller PE Ratio

This site is offering a great information on the SP500 and the sectors' Shiller PE Ratios that's updated daily. As you can see, all sectors are currently overvalued, with only Energy sector the exception at 17. At 17, it's not really considered as undervalued because its PE Ratio has to be below 15 to be qualified as undervalued. SP500 Shiller PE Ratio is currently at 30.

Screenshot: http://www.multpl.com/shiller-pe/

It's fair to say that the market won't really crash even it's overvalued because it could stay so for a long time, especially from a long-term investor's perspective. However, we can see from the graph above that when it's above 25, it definitely deserves a wide-eye look, especially when it is currently at a level that resembles the level during the tragic 1928 crash. Of course, this is not a benchmark that will signal whether the crash is coming soon or not, but this tells us that fundamentally SP500 is currently overvalued at a very alarming level that should make you think more than twice if you think this bull run is going to continue forever from now.

You might notice that I did not talk about the technicals. Technicals aren't really my favourite part because it always doesn't seem to make sense for me, but it deserves an examination because it is being widely used by the market players so its impact in influencing the market's emotion should not be neglected. For simplicity purpose, I'd skip the technicals because there are many articles about it every day (the media loves to talk about it), but there's one I'd like to highlight:

VIX a.k.a. investor gauge

There's a growing concern on the very low level of VIX that suggests the market is complacent about the current level of the stock market and that is very dangerous. But I do not appreciate this kind of concern based solely on VIX at the moment because it doesn't seem to a meaningful relationship between the recession and VIX as shown in the graph below.

I agree that VIX is currently at a very low level, but this does not signal any crash ahead because historically it's showed that it can stay low for a long time and still nothing happened, and it actually rebounded before the recession, which I think make perfect sense because it showed the market has sensed something was brewing underneath, thus the sentiment was weaker and it reflected on the VIX. Generally, I think VIX should be just a lagging sentiment indicator that tells us about the current mood of the market: above 15 (scared), above 20 (super scared). Below 15? Hmm... just fine. But I agree that when it's below 10, the market is at the euphoria stage, which means the market is getting extremely greedy and not cautious of anything. As Warren Buffet says... be fearful when others are greedy. As the past evidence shows, VIX implies that you should be watching out when it goes beyond 20, and obviously now it's not yet.

Dow Jones Transportation Average vs Dow Jones Industrials Average

According to the Dow Theory, the DJTA should follow the trend of DJTI. Failing of so would indicate weakness of the economy ahead and potential reversal of the trend.

As we can see from the chart above, the DJTA does not confirm the trend of DJTI and it is potentially a double top in the making. This signals a weak U.S. economy ahead as what the U.S. companies produce do not get transported by the transports into the hand of the consumers.

Gold Price

Gold often has a super parabolic run for months before any major crash kicks in. From the chart below, you can see that the price of gold went up wildly at the end of 2007 before the real shit happened in 2008 and it tanked together with the market.

This chart also shows that the gold price is rather stable now, there's no parabolic curve in sight.

Thoughts:

While I agree that there might be a correction between August and September, I don't think this correction will lead to a crash then a recession yet. It still largely depends on the geopolitical state, the Fed's monetary policy, corporate earnings, etc, which nothing bad that has already CONFIRMED has actually happened, but because many good news that haven't been confirmed has been priced in, a correction is expected. Fundamentally, the market is obviously super over-valued with the Real Estate and Technology sectors being the most over-valued ones, but I think this only tells us that when it finally crashes, it will crash super hard. It tells nothing about WHEN WILL IT CRASH because it's us-- emotional humans that will decide when. But ironically, none of us actually know the exact date. The macros only tell me that there're definitely reasons to get worried, but the crash is not coming now.

Will I get wrong? Of course I might, I'm just a beginner in this industry, I'm one of those millennials that is new and haven't experienced any of the traumatic crash yet.

Will the macros be wrong? May be, because life is full of unexpected events.

Will the crash comes suddenly without any warning from the macros side within these coming 2 months? It's not fair to say that no warning has been granted given the fundamentals of the market, but I think it's quite unlikely because if it does happen it'll probably be the doomsday.

A late cycle often lasted about 1.5 year with about 5% return. During this time, we will see an overheated economy, above-trend inflation rates, restrictive monetary policy, economic growth rates being slow, deteriorating profit margins, inventories build unexpectedly, sales growth declining and etc. The Fed often says they're raising interest rate to prevent an overheated economy, but what's an overheated economy? According to www.investopedia.com:

The market generally expects from the Fed's hint that there'll only be one more rate hike this year, which is fewer than we had anticipated before, this shows that the economy is not really heated yet. One of the main reasons is probably because of the oil price. The inflation rate shows sign of slowing because of the oil price hasn't really rebounded significantly. As there's still ongoing fight between the oil producers, I don't expect any good news from the oil industry. So this gives me another confidence that the time is not now yet in the coming 2 months. So my conclusion is...

Taklah, bukan kali inilah :)

#Macros