5 signs of trouble in the stock market

1. The inverted yield curve

In the normal course of events, longer-term interest rates are higher than shorter-term rates. It all has to do with risk. Since longer-term securities tie up your money for extended periods, investors typically demand higher interest rates than for short-term securities.

An inverted yield curve takes place when the situation reverses. Investors are willing to accept lower returns on longer-term debt securities than on shorter-term ones. A significant reason for the inverted yield curve is the expectation by investors that future investment returns will be lower than they are now. Investors flock to safe intermediate-term U.S. Treasury securities to lock in current yields as protection against lower returns in other assets, primarily stocks.

Yet another troubling issue with the inverted yield curve is that one has proceeded each of the last seven recessions, going back to 1956. Recessions are also bad for stocks because they lead to increased unemployment, lower corporate profits, and ultimately lower stock prices.

To illustrate the point, below is a screenshot of the U.S. Department of the Treasury's Daily Treasury Yield Curve Rates for July 23, 2019:

Daily Treasury Yield Curve Rates for July 23, 2019

You can see the yield on the one-month Treasury bill is 2.12%. But as you make your way across the row of interest rates, you'll notice that returns on securities ranging from three months to 10 years are lower than the yield on the one-month bill.

Of particular interest are the yields on the five-year Treasury note, currently at 1.83% and on the 10-year note at 2.08%. The fact that investors are willing to accept lower rates on securities ranging from five to 10 years than they are on one-month security is highly abnormal and a definite warning sign.

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2. Widespread complacency

This is really about market sentiment or how investors perceive the financial markets. In general, positive sentiment is consistent with a rising market. Negative sentiment is indicative of a bear market.

Several factors can affect sentiment, including political developments, pronouncements by the Federal Reserve, and geopolitical conditions. There are also economic indicators. For example, trends in the Consumer Price Index (CPI) may indicate future inflation. That can foretell an increase in interest rates, which is generally bad for stocks.

Rising government deficits can also point toward higher interest rates since the U.S. government is the largest debtor of all. Conversely, a rising unemployment rate can point toward a weakening economy, which will negatively impact corporate profits and, eventually, stock prices.

Any of these can affect market sentiment, but even more so if several are heading in the wrong direction. Since market sentiment is based primarily on emotion, it can shift at any time. Ironically, the positive market sentiment itself can be an indication of a market top and darker days in the stock market.

Common measures of market sentiment

Investors and analysts look at several objective measures of market sentiment to determine investor mindset. Individually, none are indicative of a shift in market direction. But two or more can be flashing warning signals that shouldn't be ignored.

Based on the current readings of the measures below, investors are displaying widespread complacency. That could be a warning sign. Bad things often happen when — and precisely because — no one thinks they can.

1. The VIX

   Often referred to as the “fear index,” it's more technically known as the CBOE Volatility Index. It measures options activity to calculate a real-time index of the expected level of price fluctuation in the S&P 500 index over the next year.

   When the index is high, it indicates more considerable uncertainty and a possibility of a significant change in stock prices. When its low, market sentiment is higher, projecting market stability. The volatility index is currently at around 12.3, compared to an average valuation of 19. The low valuation suggests traders expect market stability, which is typically good for stock prices.

2. Short Interest

   When an investor shorts a stock, it's done in anticipation of a major drop in price. The investor will gain if the stock falls. Short interest is the number of shares that have been sold short but have not been either covered or closed out. It's expressed as a number or percentage. High short interest indicates pessimism, while low short interest indicates optimistic sentiment.

   But in an ironic twist, high short interest can also indicate strong future performance in the market. It indicates extreme pessimism, and stocks are known to “climb the wall of worry.” High short interest means there is a large number of investors in short positions who will need to buy back the shares they short sold if the market climbs, causing prices to rise even more.

   The current level of short interest is just about at the middle of the range for the past ten years, which is a neutral indicator.

3. Moving Averages

   This indicator uses the 50-day simple moving average (SMA) and 200-day SMA to measure market sentiment. When the 50-day is higher than the 200-day, it indicates a bullish sentiment. But when the 50-day is below the 200-day, it indicates a bearish sentiment.

4. The High-Low Index

   This index compares the number of stocks reaching 52-week highs versus the number hitting their 52-week lows. An index rating below 30 indicates bearish sentiment, while a reading above 70 represents bullish sentiment. (50 is the dividing line.) For most of 2019, there have been more new highs than new lows, indicating positive sentiment.

   This could point to higher stock prices ahead. Or it could be another marker of the widespread complacency that proceeds bear markets.

3. Excessive valuations

The current price-to-earnings (P/E) ratio on the S&P 500 is sitting right around 22. Since the historic average P/E ratio on the S&P 500 is about 15, the current level may indicate the market is overvalued by about 33%.

However, the current level isn't necessarily pointing to trouble. The trailing P/E on the S&P 500 has been hovering around the 22 mark going all the way back to 2014. That means we've sustained a relatively high market P/E ratio for five years without experiencing a significant downturn.

The consistency of the P/E ratio may even be pointing to 22 as the new normal.

Given that interest rates are also currently at historic lows and have been trending in the same general range since 2009, the higher P/E ratio on the market may be less a problem. After all, technically speaking, the P/E ratio on the 10-year U.S. Treasury note is currently sitting at about 48.5 (100 divided by the interest rate yield of 2.06%).

Given the very low yields on intermediate-term U.S. government securities, investors may be much less concerned with the higher than normal P/E ratios on stocks. The potential for continued price appreciation in stocks may outweigh the perceived risks of the higher P/E. And we have five years of higher P/E ratios to support that conclusion.

But that doesn't mean high P/E ratios are signaling “all Is well”

The market may not ignore high P/E ratios forever. While it may not be an issue in the current market, a triggering event could suddenly cause high P/E ratios to be an underrated risk. It could turn into one of those moments when investors look back and ask, “What were we thinking?”

For example, an unexpected increase in interest rates could change investor sentiment about P/E ratios. Stocks could begin falling, starting with those companies with higher P/E ratios. Once the high flyers begin to sell off, it could start a chain reaction that leads to a bigger than expected decline in stock prices.

That is what happened in the last two stock market crashes. When the dot-com bubble burst in 2000, the significant slide in stocks was led by tech companies, then spread to the entire market. Similarly, the crash that attended the 2008 Financial Meltdown was led by financial stocks, starting with companies connected with the mortgage industry. Once again, the crash began in one specific sector, then went market-wide afterward.

Perhaps the moral of the story is that high P/E ratios don't matter — until they do.

There's still one more potential sign of trouble related to excess valuations. The four biggest stock market crashes in history — 1929, 1987, 2000 and 2007 — were each preceded by record stock prices. 2019 has produced the highest stock market levels in history.

It's not that a high stock market in itself is indicative of a declining market. Rather, it's that crashes begin with record stock prices. When valuations reach record levels, the potential is real that a relatively minor decline in the market could quickly evolve into a major selloff or even another full-blown crash.

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4. Declining credit quality

The entire U.S. economy runs on credit, including businesses large and small. When credit is expanding, the economy is growing and all is well. But that's as long as credit performance remains steady. A deterioration in loan performance is a definite sign of trouble for the stock market.

How are we doing with credit performance right now?

• Mortgage delinquencies are at 2.67% through May 2019 and have declined steadily since the peak in 2010.
• Credit card delinquencies have increased slightly to 2.59% after falling to a low of 2.12% in the first quarter of 2015.
• The delinquency rate on installment loans, which include home equity, property improvement, mobile home, auto, recreational vehicle, marine and personal loans, sit at just 1.78%, which is below the pre-recession average of 2.09%.
• Commercial and industrial loans have been holding pretty steady just above 1% since 2012.

In looking at current loan performance, there are no signs of trouble for the stock market at this time. Credit performance is continuing to be solid.

5. Irrational exuberance — or, any news is good news

Remember earlier when I wrote that a major market decline could be set off by a triggering event? That's usually the revelation of unexpected bad news, frequently referred to as a black swan event.

But apart from a truly unexpected crisis, there's plenty of trouble brewing in the economic and global backgrounds. As is typical of bull markets, bad news tends to be ignored — at least until it becomes a recognized crisis.

Be prepared for the worst to happen

With Wall Street volatility, stores running out of supplies as customers stock up on toilet paper and water, and major economies like China at a standstill as the coronavirus spreads, the stock market may be in real danger of running on what Alan Greenspan once referred to as irrational exuberance. That's exactly how every bubble in human history plays out.

But even more important, it's time to take serious stock in what Warren Buffett once said:

Rule Number 1: Never lose money.Rule Number 2: Never forget Rule Number 1.

A little bit of advanced preparation could go a long way toward preserving your portfolio. This may not be a time to bail out, but it's certainly an opportunity to take some profits and reduce your exposure.