After Defying Rationality, Stock Market Poised to Crash

If this stock market seems to defy both gravity and rationality, you’re not crazy.

Corporate profits are barely growing, yet the stock market has continued its uprward march this year.

However, largely because of oil-ravaged energy companies and the strength of the dollar, second-quarter earnings from S&P 500 companies are largely flat.

About 44 percent of the revenues from S&P 500 companies come from outside the United States, and the global slump is starting to hurt US markets.

Fully one-third of the companies in the Russell 2000 stock index do not earn any profits, the highest percentage in a non-recessionary period, notes Francis Gannon, co-chief investment officer at Royce Funds. And through the second quarter, a majority of the performance in the Russell 2000 index came from companies that lost money before interest, taxes, depreciation and amortization.

Corporate buybacks are artificially raising share prices, which has created a false sense of health. But cracks are finally showing.

The S&P 500 is now down 1.1 percent this year.

Meanwhile, the Dow is down 2 percent year-to-date, while the Nasdaq is up just 6 percent.

Despite this weak performance, stocks aren’t cheap. The US equity market is trading at a richer valuation than most others.

Professor Robert Shiller’s cyclically adjusted price earnings ratio (CAPE) for the S&P 500 stands at 27.2, some 64 percent above its historic average of 16.6. On only three occasions since 1882 has it been higher – in 1929, 2000 and 2007.

Market crashes followed each time.

In a normal world, stocks would be challenged to move higher in the absence of real earnings growth.

Yet, reality may finally be setting in. We may be witnessing the beginning of a long overdue decline in this six-year bull run.

Absent profits and earnings, how long will investors continue to play this game of roulette?

Historically low interest rates have provided few alternatives for investors. Up until now, there’s been little sense in buying government bonds, or putting your money in a bank CD (which seems positively old fashioned at this point) when the stock market has continued an upward ascent.

However, those ultra-low rates have driven a lot of people into stocks who would not normally be there. That money could exit the markets quickly once rates start to normalize, or if the markets continue to tumble.

The perceived safety of Treasuries and other safe havens, such as gold, could see huge inflows of money.

Another concern is the level of borrowing to fund stock investments. The use of 'leverage' to buy stocks is very near its peak.

According to the New York Stock Exchange, margin debt stood at $505 billion in June, the most recent figure available. That’s down just a bit from the April peak of $507 billion, but up 9 percent from the same period last year.

That's a recipe for disaster.

This is the third-longest bull market in 80 years. There is bound to be a significant correction (likely an outright crash) sooner than later, and it may have already begun.

Economies around the world are slowing, from the biggest to the smallest. That’s putting downward pressure on global markets and, worst of all, creating fear.

Markets don’t like fear; it creates a mad rush to the exits.

As the Romans once implored, "caveat emptor."

Or, in today’s parlance, "buyer beware."