Since early 2013 the US stock markets have done nothing but rally, levitating thanks to the Fed’s oft-implied backstop.  This incredibly unnatural behavior has left sentiment dangerously unbalanced, with hyper-complacency and euphoria running rampant.  Only a major selloff can restore normal psychology.  And with the Fed’s third quantitative-easing campaign ending, odds are high such a big downside event looms.

Stock markets are forever cyclical.  Stock prices don’t move in straight lines forever, they endlessly rise and fall.  Great cyclical bulls that earn investors fortunes are followed by brutal cyclical bears that create the best opportunities to buy low again.  The perpetual cyclicality of the stock markets reminds me of Mark Twain’s famous weather quip.  If you don’t like current stock prices, just wait a spell and they’ll change!

The rising and falling of stock markets is fractal in nature, repeating at different scales.  There are great 17-year secular bulls and bears driven by valuations, the markets’ overarching cycles.  Within them are still-large cyclical bulls and bears, generally lasting from 2 to 5 years each.  And then in turn these are punctuated by smaller countertrend moves, corrections inside cyclical bulls and bear-market rallies in bears.

These mid-cyclical-bull selloffs are exceedingly important for the bulls’ health.   When stock prices rise, the great sentiment pendulum swings ever farther towards the greed extreme of its arc.  If the excessive optimism that rising stocks always create grows too unbalanced, all near-future buying is sucked in.  So the stock rally soon burns itself out, leaving nothing but sellers.  This dynamic is what breeds stock selloffs.

The serious risk today is that these selloffs tend to be proportional to the rallies that led into them.  The longer stock markets climb without a major selloff to rebalance sentiment, the more unbalanced trader psychology becomes to the greed side.  This necessitates commensurately larger and/or sharper selloffs to bleed off the excess euphoria and bring sentiment back into line.  That means we are in for a doozy of one today!

For the better part of two years now, the American Federal Reserve has tirelessly worked to short-circuit every nascent stock-market selloff.  Both by actively creating new dollars out of thin air to monetize debt, and by incessantly jawboning about further easing, the Fed convinced stock traders that it would be quick to respond to any stock-market weakness.  So they bought and bought, nipping every selloff in the bud.

But with no real selloffs, sentiment couldn’t be rebalanced.  Thus greed, euphoria, complacency, and even hubris flourished immensely.  This pulled vast amounts of buying forward, effectively bullying far more investors into buying stocks than would’ve otherwise done so in normal markets.  This so-called Fed Put led to the most distorted, overvalued, overextended, and risky markets we’ve seen since the early-2000 bubble.

The Fed’s insanely-reckless actions merely delayed the inevitable selloff, and ensured it is going to be a heck of a lot larger than normal.  This reminds me of wildfire suppression.  The more often firefighters rush to extinguish little fires, the thicker underbrush grows.  All that fuel is a time bomb, just waiting for the right conditions and spark.  The resulting massive and terrible conflagration finally rebalances the system.

To illustrate just how choked up with tinder-dry greed today’s Fed-distorted stock markets are, I built a couple charts.  They superimpose the flagship SPDR S&P 500 ETF (SPY) over the famous VIX implied-volatility fear gauge. Since the Federal Reserve had never done anything remotely like the open-ended QE3 bond monetizations in its entire century-long history, no one has ever witnessed markets like these before.

The Fed’s totally unprecedented third quantitative-easing campaign was hatched back in September 2012, and then more than doubled a few months later in December.  That’s when stock traders started to believe the Fed would swiftly arrest any material stock-market selloff, thus the levitation was born. Ever since then, stocks have essentially done nothing but rise.  All selloffs were stunted before they could mature.

Stock-market selloffs are categorized by size.  Anything under 4% on the benchmark S&P 500 (SPX) is nothing but noise, it doesn’t even qualify for a formal label.  Such trivial selloffs naturally do nothing at all to eradicate excessive greed, so they are usually ignored.  But thanks to the Fed’s implied backstop on stock markets, they’ve dominated its QE3 levitation.  The larger ones are noted in this chart in green.

Once a selloff gets over 4%, it’s classified as a formal pullback.  Selloffs of this magnitude start to demand traders’ attention, sending cracks cascading through the universal greed that arises when stocks grow too overbought.  In normal healthy bull markets, pullback-magnitude selloffs are seen several times a year or so.  But thanks to the Fed, we’ve only seen 4 in this levitation that were oddly clustered in its middle.

Pullbacks certainly aren’t major selloffs, that designation only comes after 10% when downside moves become actual corrections.  These do the most work in rebalancing sentiment by far, greatly reducing greed and ramping fear by their ends.  Like underbrush getting burned out, that leaves bull markets in a healthy state psychologically ready to be bid higher again.  Corrections happen once a year or so on average.

But in the 22.1 months between SPY’s November-2012 bottom and its latest high last week, this mighty S&P 500 ETF has soared 48.7% higher without a single correction-magnitude selloff!  With the Fed Put in force, the markets didn’t even get close to 10%.  Their largest pullback was merely 6.0% over a month or so in June 2013 when Ben Bernanke initially outlined the Fed’s best-case timeline for tapering QE3.

Nearly two years without a real correction to rebalance sentiment in a powerful bull is an extraordinary span of time.  To the best of my knowledge, comparable episodes have only been seen historically in rare times when major bull markets are topping.  So much greed and euphoria are generated during a long, low-volatility, correction-less span that future stock buying is universally pulled forward killing the bull.

It’s been so long since the last correction that most epically-complacent stock traders have likely forgotten just how nasty and dangerous they are.  On the right side of this chart, I noted the SPY levels necessary for 5%, 10%, 15%, and 20% selloffs from its recent peak.  Merely falling 10%, a baby correction, would leave SPY near $182.  That would take it back to late-2013 levels, totally erasing this entire year’s gains!

But like those wildfires, the longer without a correction the more greed underbrush grows so the bigger the selloff when it eventually arrives.  So the odds are very high that the coming major selloff will stretch far beyond 10%, up into the 15% or even 20% range of full-blown corrections.  At 15%, SPY would drop near $172 taking it back to levels first seen over a year ago. Imagine the dire psychological impact of that.

Technically once a selloff hits 20%, it formally becomes a bear market.  But major corrections often edge right up to this 20% to maximize their greed destruction and fear generation.  Since it’s easier to think in terms of 20% instead of the high 19s, a serious correction would hammer SPY all the way back down near $161.  These levels were first seen in the spring of 2013, so that would erase most of the Fed’s levitation!

Major corrections are certainly not trivial events that should be haughtily dismissed.  They wipe out a fifth of the capital in the entire stock markets, with the higher-flying stocks popular among traders suffering far worse declines!  And with each passing day since the end of the last correction, the higher the odds grow that the next one is imminent.  The sentiment pendulum can’t swing into greed territory forever.

Greed and fear are of course ethereal, they can’t be directly measured.  But overall market psychology can be inferred through a wide variety of indicators.  The premier one is the VIX implied-volatility index.  It measures speculators’ collective bets on S&P 500 index options over the coming month.  The wider the range of bets in price terms, the greater the volatility expected.  And high volatility equates to fear.

Provocatively the three biggest pullbacks of the Fed’s SPX levitation saw the VIX spike above 20.  So even if you’ve drank the bulls’ Kool-Aid and believe a major selloff isn’t necessary, not even a meaningful pullback is likely to end until the VIX catapults above 20 again.  That means this past week’s selloff, even if the Fed’s stock-market levitation magically continues, still hasn’t generated enough fear yet.

As a contrarian investor, I’ve grown rich betting against popular consensus. That’s the only way to buy low and sell high consistently.  So I continue to strongly believe that this Fed-driven anomaly in the stock markets is so extreme fundamentally, technically, and sentimentally that only a new cyclical bear can restore normal balance on those fronts.  Remember stock markets are forever cyclical, bears always follow bulls.

This next chart zooms out to encompass the entire cyclical bull since March 2009, most of which was totally righteous.  The extreme Fed distortions didn’t come until early 2013, late in this bull’s life.  I was super-bullish publicly on the record in March 2009 at this bull’s birth, and then again in July 2010 andin October 2011 when stock markets were bottoming after major corrections. Contrarians buy low during fear.

Normal cyclical bull markets start off with rocket-like ascents out of the extreme fear pervasive at the ends of cyclical bears.  But then their trajectories slowly taper off into the horizontal parabola rendered above in yellow.  Everything was again normal until early 2013, when the Fed started jawboning about not letting the stock markets sell off.  The resulting SPX levitation’s decoupling is crystal-clear in this chart.

The first four years of this bull saw normal and healthy corrections periodically to rebalance sentiment.  The first one started 13.5 months into this bull, and the second began 9.9 months after the first one ended.  They were major full-blown selloffs at 16.1% in SPY terms over 2.3 months in mid-2010, and a near-the-limit 19.4% over 5.2 months in mid-2011.  These corrections kept this bull healthy, bleeding off excess greed.

But since the end of that last correction in early October 2011, it has been a jaw-dropping 35.5 months!  That’s an astounding three years without sentiment being rebalanced, without the greed-drenched underbrush being burned away!  The amount of complacency, greed, euphoria, and hubris that can grow in such a long, unchecked span of rapidly rallying stocks is epic.  It is going to fuel a massive selloff.

Even if you’re one of the legions of optimists somehow betting this cyclical bull has years left to run yet, a long-overdue 20% correction will erase most of the Fed’s levitation.  If that’s all we are in for and this geriatric bull still has legs, the all-clear signal will be a gigantic VIX spike higher.  This definitive fear gauge had to rocket above 45 before each of this bull’s last two corrections ended.  We are nowhere close yet.

But the case for a new cyclical bear is far stronger, nearly ironclad after such an outsized bull.  This one has seen SPY nearly triple with a staggering 196.3% gain over 66.4 months.  This is far beyond the average size and duration of mid-secular-bear cyclical bulls of a doubling in 34.8 months. Stock bulls simply don’t power higher forever, and thanks to the Fed this one’s magnitude and age are truly extreme.

So much rallying for so long has naturally left stock-market valuations extreme too.  Today’s stock prices are simply far too high relative to their underlying earnings by all historic standards.  As of the end of last month, the trailing-twelve-month price-to-earnings ratios of all S&P 500 stocks averaged a breathtaking 26.0x!  This isn’t far from 28x bubble territory, and nearly twice the century-plus 14x fair-value standard.

And in addition to extreme technicals and fundamentals, sentiment is also extreme.  Back in early July, the VIX fell to 10.3.  It hadn’t been so low since February 2007, heading into the top of the last cyclical bull in October 2007 before the S&P 500 rolled over into a brutal cyclical bear where it ultimately lost 56.8%!  But ominously today’s Fed-manipulated sentiment is even more complacent than back then!

The original old-school VIX which only applied to the top fifth of SPX stocks, the S&P 100, now trades as VXO.  It remains a superior fear gauge, as it only looks at at-the-money options of the elite S&P 100 instead of the new VIX’s broader range for the entire S&P 500.  During major selloffs, the biggest and best SPX stocks are sold fastest since they have the most liquidity and trading volume to absorb the selling.

In early July 2014, that classic old-school VIX now known as the VXO fell to a mindboggling 8.5.  This was its lowest level ever seen, an all-time record! That’s saying a lot for an index that’s been calculated back to January 1986, that saw the extreme complacency before the infamous 1987 stock-market crash and during the early-2000 bubble.  Fear at an all-time low measured by the VXO is as extreme as you can get!

So with the Fed’s totally artificial levitation forcing the US stock markets’ technicals, fundamentals, and sentiment to crazy extremes, it’s hard not to imagine a new cyclical bear looming.  And the losses that would entail ought to terrify today’s hyper-complacent investors.  Cyclical bears tend to cut the stock markets in half!  50% losses are devastating beyond belief for investors, especially older ones nearing retirement.

I marked bear-magnitude losses on the chart above.  At 30%, SPY would fall near $141.  That would take it back to early-2012 levels erasing about half of this entire bull’s gains.  At 40%, SPY would drop near $121 which was first seen way back in mid-2010.  And at a full-blown 50% cyclical bear, SPY would ultimately bottom near $101 which would slash it to mid-2009 levels eradicating nearly this entire bull’s gains!

Can you stomach that kind of risk today?  Best case even if this bull magically continues for years to come as Wall Street is trying to dupe investors into believing, we are in for a massive correction nearing 20% to rebalance sentiment.  Worst case, we are looking at a new cyclical bear that is likely to cut stock prices in half over a couple years.  With very-high odds for a major selloff, why take the risk of sitting in lofty stocks?

And greatly amplifying this already-suffocating downside risk, the perfect catalyst for a major selloff is here.  At last week’s FOMC meeting, the Fed declared in its statement that “the Committee will end its current program of asset purchases at its next meeting.”  That means QE3, the inflationary debt-monetization campaign that levitated the stock markets for nearly two years, is scheduled to end on October 29th!

Just a month from now the QE new-buying era ends, leaving the Fed bereft of the ability to convince traders it is backstopping stock markets.  Harsh political realities make launching QE4 risky to the Fed’s very existence.  The imminent end of QE3 is the best catalyst we’ve seen for sparking a major correction or new bear market since QE3 was launched.  The precedent on this is crystal-clear, the ends of both QE1 and QE2.

The first major correction of this cyclical bull in mid-2010 was triggered when QE1’s buying was ending.  And the next major correction in mid-2011 eruptedwhen QE2’s buying was ending.  These once again were not trivial selloffs, with SPY plunging 16.1% and 19.4%.  And the stock markets then were far less risky, overextended, overvalued, and complacent than they are today. QE3’s impending end is truly ominous.

So what should prudent investors do?  Sell dangerously-overvalued stocks high and buy dirt-cheap gold low.  While stocks are adored thanks to the Fed, gold is loathed.  Its price is due to mean revert radically higher as the artificially-levitated stock markets roll over.  Gold is a proven performerduring stock bears, having rallied nicely during the last two since 2000. Alternative investments shine when stocks are weak.

You also need to cultivate an essential contrarian perspective on the markets. Cyclical bears unfold gradually over a couple years or so, and Wall Street won’t admit we are in one until it is almost over and catastrophic losses have already been suffered.  The only way to protect yourself and your precious capital from Wall Street groupthink is to learn to fight the herd to buy low and sell high like a contrarian.

That’s what we do at Zeal.  We’ve spent decades intensely studying and trading the markets so you don’t have to.  We publish acclaimed weekly andmonthly newsletters that draw on our hard-won experience, knowledge, wisdom, and ongoing research to explain what’s happening in the markets, why, and how to trade them with specific stocks.  Since 2001, all 686 newsletter stock trades have averaged stellar annualized realized gains of +22.6%!  Subscribe today before the markets reverse!

The bottom line is stock markets rise and fall.  And thanks to the Fed’s gross distortions of psychology, today’s are overextended, overvalued, and epically complacent.  That means a major selloff is long overdue to rebalance sentiment.  Best case if the bulls are right, it will be a major correction approaching 20% like at the ends of QE1 and QE2.  But far more likely is a new cyclical bear ultimately cutting stocks in half.

Naive investors trapped largely unaware in it will suffer catastrophic losses most won’t have time to recover from.  But the smart ones will prudently sell high while this long-in-the-tooth stock bull is still topping.  Then they can grow their capital through alternative investments while this looming bear runs its course.  They will be perfectly positioned to buy low as it ends, and multiply their fortunes in the next bull.

Adam Hamilton, CPA

September 26, 2014

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