Stocks Take A Pause… Will Fundamentals Catch Up?

Amber Hestla's picture

Thursday, May 30, 2019 - 12:00am

by Amber Hestla

Last week, the Dow Jones Industrial Average finished lower for the fifth week in a row. 

That sounds important -- and it is -- but I will get to that in a moment. First, I want to step back and take a long-term view. 


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Here's a monthly chart of the Dow Jones Industrial Average that goes back over the past 15 years. As you can see, there was a clear multi-year uptrend in the Dow that started back in 2009. 

Dow chart

But since January 2018, that uptrend has stalled. 

Technical analysts would say prices have been in a consolidation since then. I highlighted the consolidation pattern with a blue rectangle. 

Charles Dow And The Business Cycle
Writing in the late 1800s, Charles Dow (known for founding The Wall Street Journal and developing the Dow Jones indexes) noted that consolidations could replace bear markets. Dow believed that it was impossible for stock prices to move in only one direction. There was an up and down pattern that he believed was related to the business cycle. 

In the 1800s, the business cycle was more volatile than it is today. On average, the country experienced a recession every four years, and the recessions were deep. The term "panic" was used to describe several recessions in the 19th century. 

The panic of 1893 saw inflation jump from 4% to as much as 18% by some estimates. There are no government statistics from that era, but the most optimistic estimate is that unemployment reached 12%. 

In 2009, when unemployment was moving toward 10%, the government initiated a trillion-dollar stimulus package to ease the pain. In the 1890s, when Dow was writing, economic and stock market volatility were much higher than today, and Dow was working to identify the relationships between the two. 

He found that bull markets invariably pushed prices too high in the sense that prices were ahead of fundamental growth. The bear market would bring prices back in line with economic growth. But he also found that consolidations could replace bear market declines. By essentially going nowhere for months, the economic fundamentals caught up to the stock market. 

This means there is room for optimism in the long run. The market's sideways action for the past 17 months might have been the equivalent of a bear market. 

There could be more back and forth in the price action, and this sideways trading range could continue for months. But the important point is that we should expect volatility -- and it's possible to benefit from volatility with a short-term focus. 

In the short term, we have a downtrend. The next chart shows the more recent market action. 

Dow weekly chart

Over the past 20 years, we have seen five-week losing streaks 19 times, an average of about once a year. The next week saw gains 68.4% of the time, with an average gain of about 1.1%. That compares to an average week where there is a 57.2% probability of a gain and the average gain is about 0.2%. 

This indicates the probability now favors a rally in the stock market this week. That could set up a move toward the all-time highs. This would increase the bullish sentiment of traders and could be the catalyst for a summer rally. 

Fundamentals Don't Matter (For Now, At Least)
Fundamentals still remain significantly overvalued, but the trading range could continue to give the fundamentals time to catch up. For now, fundamentals don't matter as much as sentiment. Investors have been ignoring fundamentals for some time. That can be seen in the next chart. 

CAPE chart

This is a chart of the CAPE ratio, the cyclically adjusted price-to-earnings (P/E) ratio. This is a P/E ratio calculated with the average earnings over the past 10 years to smooth out the ups and downs of the business cycle that Dow identified as the cause of long-term trends in the price action. Earnings are also adjusted for inflation to make them directly comparable over time. 

The current reading of the CAPE is 30.2. It's only been higher two times since 1880. Once was in 1929 and the second time was in 2000. Eventually, deep bear markets followed the peaks in CAPE. But CAPE was elevated a year before the crash in 1929 and for three years before the crash in 2000. 

Action To Take
This bull market will end badly, but the end is unlikely to be at hand for at least a few months. In the meantime, we face a complex market environment that could be extraordinarily profitable for traders. We will need to monitor the short-term and long-term indicators because volatility is increasing, and we will need to be active in order to benefit. 

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Amber Hestla does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.