6 Forces That May Push the Stock Market Even Lower

While bullish investors breathed a sigh of relief on Tuesday, as stocks rebounded from steep declines on Monday, the bears still have plenty of grist for their mill. In particular, six key negative forces continue to overhang the markets, according to Bloomberg. These forces include: highly overbought conditions; record high stock valuations; rising bond yields; looming Federal Reserve rate hikes; inflationary pressures; and cost pressures on corporate profits. For good measure, one could toss in a seventh force, so-called short-vol trading pressures. (For related reading, see also: 5 Reasons the Bull Market Will Thrive in 2018.)

On February 6, the S&P 500 Index (SPX) rose 1.74% on the day, while the Dow Jones Industrial Average (DJIA) gained 2.33%. Nonetheless, the forces mentioned above and detailed below are likely to weigh on stocks throughout 2018.

Short-Vol Pressures

In recent years, the CBOE Volatility Index (VIX) has hovered near all-time lows for extended periods. As described by Barron's, in 2017 many traders found what they thought to be a surefire, foolproof way to make money. The strategy involved executing short sales of futures contracts on the VIX that implied a higher future degree of market volatility than that currently measured by the VIX. The value of these futures contracts thus would exceed the current spot price of the VIX, a situation called contango in futures market jargon. As long as the VIX stayed low, the value of these contracts would fall to meet the spot price, and the speculators would be able to cover their short bets at a profit.

For most of 2017, and into January 2018, this short-volatility, or short-vol, strategy was a winning bet since the VIX remained low and relatively stable. When the VIX spiked upwards in recent trading, exceeding the future values at which those short sales were entered into, the speculators playing this game suffered big losses. Raising the cash to close out their positions at a loss contributed to the selloff in stocks, with the highly leveraged nature of these positions magnifying the effect.

According to Bloomberg, the unraveling of the short-vol strategy also appears to have touched off a wave of selling from computerized trading algorithms. Barron's sees echoes of Black Monday and the 1987 Stock Market Crash, in which computerized program trading and so-called portfolio insurance unleashed a tidal wave of selling that turned what might have been a modest selloff into a 22% plunge. Barron's also notes that the 2007 subprime crisis, the 2008 financial crisis  and the attendant bear market also had roots in derivatives gone haywire.

Positive Trends

To be sure, the bulls still shrug off all the reasons for pessimism. They see such positive factors as: rising corporate earnings; strong, coordinated GDP growth worldwide; market valuations that have stabilized; and interest rates that are still very low by historic standards, in spite of recent increases and expected increases. (For more, see also: Why Stocks Won't Crash Like 1987: Goldman Sachs.)

Negative Forces Remain

While the short-vol pressure on the equity market may be fleeting, the other six negative forces remain. The weekly relative strength index (RSI) was signaling the most overbought conditions ever for the S&P 500 Index (SPX) as of January 25, per Bloomberg, which cited analysis by Citigroup indicating that a market decline of 20% would be necessary to return the RSI to its recent trend line. While a 10% decline is the accepted definition of a correction, a 20% pullback usually denotes a bear market. If Citigroup is right, the current downturn in stock prices is less than halfway done.

The valuation of stocks in the S&P 500, meanwhile, is at a level comparable to that in two great market bubbles, the 1920s stock market boom that preceded the 1929 Stock Market Crash, and in the Dotcom Bubble of the late 1990s. Using the Cyclically-Adjusted Price/Earnings Ratio, also known as the CAPE ratio or as the Shiller P/E ratio, Bloomberg notes that this valuation metric is now more than two standard deviations above its average for the last century, a lofty level only reached twice before, in those two instances just mentioned.

Meanwhile, bond yields have been rising, and speculation is rife that the Federal Reserve may raise interest rates four times this year. The economic outlook is robust, with low unemployment, a high rate of job creation, and mounting wage pressures, all of which are raising concerns about inflation, which the Fed is committed to restrain with rate hikes. Rising interest rates, meanwhile, will depress stock prices.

Finally, while the recent tax cuts are increasing corporate profits, they may have some negative feedback loops, as they contribute to inflationary pressures and a rise in interest rates. These, in turn, will raise the cost of labor and other inputs for businesses, as well as their cost of funds, thereby eating into profits and reported earnings per share (EPS).

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