The S&P 500 Index (SPX) has pulled back from near record highs in recent days amid President Trump's threat to hike tariffs on Chinese goods, but much steeper declines may be ahead, according to several noteworthy market watchers. "We see some eerie similarities between current conditions in the stock market and those that preceded the S&P 500's peaks in January and September [of 2018] on our sentiment and valuation models," Lori Calvasina, head of U.S. equity strategy at RBC Capital Markets, observed in a note to clients, per Business Insider. Calvasina said she expects a market reversal ahead.

The S&P 500 fell about 10% from top to bottom after reaching its January 2018 peak. The market then badly shook the nerves of investors by plunging nearly 20% on a closing basis after the September peak, a hair short of the official definition of a bear market, before staging a surprising rebound.

Stocks were up slightly at noon on Wednesday, partly recouping the market's losses from its new all-time high on May 1.

But market watchers say several of factors may push stocks down sharply, including U.S.-China tensions, high valuations, and investor overconfidence that the Fed will maintain its dovish stance.

Vincent Deluard, head of global macro research and strategy at INTL FCStone, shares Calvasina's bearish view. He warns that stock market "[valuation] multiples are entering the danger zone," per another report in BI. And Seth Carpenter, the chief U.S. economist at UBS, says investors are too confident that the Federal Reserve will remain dovish. “Discussing even the possibility of a rate hike this year may seem premature, but we can no longer rule it out: A rate hike is a risk. The [Federal Open Market] Committee may turn increasingly hawkish sooner than anticipated," he wrote recently, as quoted by Bloomberg.

Danger Signs For The Stock Market

  • Investor complacency about the Fed's dovish turn
  • High stock market valuations
  • S&P 500 Sharpe ratio near highs last seen before early 2018 selloff
  • Low levels of short selling indicates excessive bullishness
  • AAII survey also shows high bullishness among individual investors

Sources: Business Insider, Bloomberg

Significance For Investors

Some observers concerned about valuation focus on the CAPE ratio, developed by Nobel Laureate economist Robert Shiller. It is currently about twice the level of its long-term average since 1871, though still well below its all-time high set during the dotcom bubble that peaked in 2000, per multpl.com.

Deluard see the same valuation problem in high forward P/E ratios for the S&P 500. "January 2018 was the only time stocks got this expensive in this cycle, but earnings were expected to grow by 30% in the next 12 months, versus 12% today," he said, per BI. "Note that even very strong earnings growth did not prevent a 10%+ correction in the first quarter of 2018," he added.

Deluard also looks at the four-month Sharpe ratio for the S&P 500, which he says is a reliable indicator of risk-adjusted excess returns. He notes that it only has been higher in late 2017 and early 2018, right before the severe correction that followed.

Looking Ahead

There are other danger signs. Deluard finds that short interest in the six largest U.S. equity ETFs is only 7.4%, one of the lowest readings ever recorded. This suggests excessive bullishness, even irrational exuberance, that market contrarians interpret as a bearish indicator. Calvasina of RBC, meanwhile, draws a similar bearish conclusion from a recent survey by the American Association of Individual Investors (AAII). That gauge indicates that retail investors have become more bullish as the 2019 rally continued.