3 Reasons To Prove the Market Is Topping Out

Source: Thinkstock

Source: Thinkstock

After a stellar 2013, the stock market has had an unimpressive 2014. While the major averages haven’t fallen they haven’t risen either — the Dow and the Nasdaq are essentially flat and the S&P 500 is up less than 2 percent. Furthermore, whenever we seem to be breaking out of this consolidation phase, stocks start to trade lower.

This indicates to me that stocks are topping out, and that we may be on the verge of a substantial correction. Keep in mind that we are long overdue for such a correction, and over time, stocks are extremely volatile assets and 20 percent corrections occur every few years. While we haven’t seen anything like that since 2011, I think that we are beginning to see signs that stocks could be setting up for a more meaningful correction.

1. Stocks are historically overvalued

Right now, the S&P 500 trades at a very high valuation. The P/E ratio of the S&P 500 is over 20, whereas historically it averages in the low to mid double digits. The dividend yield on the S&P 500 is also historically low at less than 2 percent, whereas historically it is closer to 4 percent. This indicates that stocks in the aggregate have significant potential downside.

We should also keep in mind that when stocks correct, they usually don’t trade down to their historical averages, but rather they trade to valuations below these averages just like when stocks rise, they rise to a level above these historical averages. While the Fed’s easy monetary policy may keep dividends low and P/E ratios high, I think we need to at least trade down somewhat in order to get back to more normal valuations.

Source: Thinkstock

Source: Thinkstock

2. Momentum stocks and growth stocks have broken down

While the broader stock market averages if you look at some of the higher growth stocks and stocks that momentum traders have been buying, it becomes evident that they are breaking down. Some of these include:

  1. Visa (NYSE:V)
  2. Amazon (NASDAQ:AMZN)
  3. Chipotle Mexican Grill (NYSE:CMG)
  4. Netflix (NASDAQ:NFLX)
  5. Starbucks (NASDAQ:SBUX)

Furthermore, we are seeing strength in defensive companies and companies that trade at relatively low P/E ratios such as:

  1. Exxon Mobil (NYSE:XOM)
  2. Johnson and Johnson (NYSE:JNJ)
  3. Microsoft (NASDAQ:MSFT)
  4. McDonald’s (NYSE:MCD)

This is a sign that investors want to own less risky stocks, and less risky assets more generally by extension. While there are inexpensive stocks and companies that are going to perform well in virtually every economic environment, the fact remains that when investors want to own less risky assets stocks in the aggregate will trade lower.

Source: Thinkstock

Source: Thinkstock

3. Defensive assets are performing incredibly well this year

The best performing assets this year are defensive assets such as Treasury bonds, gold, utility stocks, consumer staples stocks, and investment grade corporate bonds. Even though the major stock market averages haven’t fallen yet, the outperformance of these sorts of assets indicates that this is where investors want to put their money. While some last minute stock investors and companies repurchasing their own shares are keeping stock prices elevated, it seems that the bulk of investors are selling riskier stocks and buying defensive assets. Furthermore, while the broader stock market averages appear to be range-bound, the defensive assets are making higher lows and higher highs, which indicates an up-trend. Unless this uptrend is broken I would be very concerned having a large position in economically sensitive stocks.

Disclosure: Ben Kramer-Miller is long Visa and Exxon Mobile.

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