Pre-Crash Indicator Near Peak Amid Trade Tensions

As stock prices languish significantly below their Jan. 26 highs, and the prospect of economically damaging trade wars mounts, a forecasting model developed by a respected investment strategist and financial commentator is flashing a danger signal for investors in a broad array of asset classes, Bloomberg reports. The indicator combines five separate market measurements. In a note to clients quoted by Bloomberg, Jim Paulsen of The Leuthold Group warns that his Markets Message Indicator "suggests investor confidence and aggressiveness 'across all financial markets' is nearly as pronounced today as it was at the last two major market tops."

The S&P 500 Index (SPX) had a 10.2% correction from its record high close on Jan. 26 through the close on Feb. 8. In each of the first three days of this week, the index has posted an intraday low that was more than 10% below the Jan. 26 high, the usual definition of a correction.

'Proceed With Caution!'

Paulsen continues, also per Bloomberg: "At a minimum, equity investors should not limit their attention simply to the struggles and messages coming from the stock market. Rather, chatter from all financial markets should be considered, and currently they are jointly whispering to 'proceed with caution!'"

The Markets Message Indicator has retreated slightly from a recent peak in January. The two previous peaks were in June 2007, four months before the start of the last bear market, and in January 2000, two months prior to the dot-com crash. Even more ominously, the January peak in Paulsen's indicator was the highest since 1980, with the exception of those in 2000 and 2007, per Leuthold data presented by Bloomberg.

Five Areas of Market Stress

The overall reading from the Markets Message Indicator seeks to synthesize, as Paulsen puts it, "chatter" from five different corners of the financial markets. These are, as summarized by Bloomberg: the relative performance of the stock and bond markets; the performance of cyclical stocks versus defensive stocks; interest rate spreads on corporate bonds; the ratio of copper to gold prices; and an index of the value of the U.S. dollar versus foreign currencies. The indicator is designed to be "a gauge that acts as a proxy for broad market stress," as Bloomberg puts it.

Since the stock market correction that ended in early February, the relative performance of stocks versus bonds has declined, as has that of cyclical stocks versus defensive stocks, per Bloomberg. Paulsen sees declining aggressiveness among investors in these trends.

Meanwhile, the interest rate spread on BBB-rated corporate bonds, which form the lowest echelon of investment grade corporate debt, has been widening. "Anxieties among bond investors are worsening," Paulsen observes, per Bloomberg, which adds that a measure of credit risk for U.S. high-yield bonds is now at its highest level since December 2016. Also, the price of gold, a traditional safe haven in times of stress, has begun to outperform that of copper, a cyclical industrial commodity, "suggesting a flight to safety driven by fear in the market," as Bloomberg puts it. 

More Bearish Signals

Technical analysts see bearish signs in the fact that the S&P 500 dipped below its 200-day moving average on Monday for the first time since June 2016, CNBC reports. The pain is broad-based, given that 10 of the 11 S&P 500 sectors were in correction territory Monday afternoon, each more than 10% below their 2018 highs, CNBC adds.

A special survey of financial professionals conducted by DataTrek Research during the week ending March 31 found 53.5% of respondents indicating that the S&P 500 will bottom out this year somewhere between 10% and 20% below its 2017 close, 38.4% saying that the bottom is near, and 8.2% believing that a true bear market decline of 20% or more will occur, per another CNBC report. However, most respondents expect stocks to be up for the full year, with 45.3% predicting a net gain of 5% or more for the S&P 500 in 2018.