Market melt-up left stocks vulnerable to a sharp reversal

The US stock market moved almost exclusively in one direction this fall: up.

This relentless rally has carried the S&P 500 more than 9% higher between October 2 and the end of November. The index hit 11 record highs last month alone — in just 20 trading days. Selloffs were virtually nonexistent as investors, afraid of missing out on the fun, stampeded back into stocks.

Melt-ups feel good — at least for those invested in stocks. But because they aren’t built on fundamentals, they make markets vulnerable to sudden pullbacks. Nothing goes straight up, not even the Nasdaq.

The recent market melt-up has left stocks priced for perfection. In other words, investors are banking on a preliminary trade agreement between the United States and China in the next two weeks. And Wall Street is betting that the worst is over for the economy. Any deviation from those assumptions could disrupt the rally.

“When everyone is leaning one way, eventually something can tip the scales the other way,” said Keith Lerner, chief market strategist at SunTrust.

Trade war fears return

The scales tipped on Monday.

First, the Institute for Supply Management said the American manufacturing downturn unexpectedly worsened in November. Manufacturing has now contracted for the fourth month in a row.

“The sector is stuck in a mild recession with little prospect of a near-term revival,” Ian Shepherdson, chief economist at Pantheon Macroeconomics, wrote in a note to clients on Monday.

Then US Commerce Secretary Wilbur Ross reminded Wall Street that the trade war may yet get worse before it gets better. Ross told Fox Business Monday that the Trump administration could increase tariffs on China if no agreement is reached by December 15.

That one-two punch of bad news drove the Dow around 200 points, or 0.8%, lower on Monday. The S&P 500 fell 0.9%, a sharp move considering the index hasn’t suffered even a 0.5% decline since October 8.

“The biggest risk to the market is that the trade stuff starts unraveling,” said Lerner. “Then all bets are off, and you could have a much more severe correction.”

That’s what happened this time last year, when the S&P 500 suffered its worst December since the Great Depression.

December is Wall Street’s best month. It wasn’t last year

It’s too early to say Monday’s market drop is the start of a new slump.

This may be just a blip on the way to new record highs, especially if a preliminary trade deal gets done. And despite last year’s S&P slide, December is typically the S&P 500’s best month of the year, according to CFRA Research.

Still, it’s clear market sentiment has reached unsustainably high levels. The CNN Business Fear & Greed Index recently hit the highest levels of “extreme greed” since the tax cut euphoria of late 2017.

“It seemed like every day we were going up,” said Peter Boockvar, chief investment officer at Bleakley Advisory Group. “Something that goes straight up, usually goes straight down.”

In addition to trade talks and hints of stabilization in the US and global economies, easy money from the Federal Reserve is also playing a major role.

Not only did the Fed cut interest rates three meetings in a row, but the central bank’s balance sheet has swelled in size as it continues to pump in money to ease stress in the overnight lending market. The Fed injected nearly $98 billion on Monday alone.

Although the Fed has said its balance sheet expansion is not aimed at boosting the economy or markets, analysts say it has in fact propelled stocks.

Michael Wilson, Morgan Stanley’s chief US equity strategist, told clients in a note on Monday that the market rally is “due primarily to excessive central bank balance sheet expansion.”

However, Wilson warned that the “liquidity tailwind will fade” by April, forcing the market to “focus more on fundamentals.” And he noted that despite the improved market mood, Morgan Stanley economists still see a 25% chance of a US recession in the next 12 months.

The FOMO factor

No matter the cause, the stock market has been on fire. And yet the underlying fundamentals — corporate profits — have been subdued. S&P 500 per-share earnings declined 0.4% during the third quarter, according to Refinitiv.

That combination of rising stock prices and weak earnings sent valuations surging.

The S&P 500’s price-to-earnings ratio stood at 16.9 in early October, according to Refinitiv. The melt-up lifted the S&P 500’s P/E ratio to 18.3 at the end of November, according to Refinitiv. The five-year average is 17.

Lofty market valuations aren’t happening in a vacuum, of course. Extremely low interest rates make stocks look more attractive by comparison. Relative to bonds, investors have decided it makes sense to pay up for stocks.

Nonetheless, SunTrust’s Lerner said that the melt-up is evidence of FOMO, or fear of missing out.

“When you continue to go up everyday and there is no pullback, it forces people into the market,” he said. “Those are not strong hands. Once the market turns, they will be quick to sell.”

Kristina Hooper, chief global market strategist at Invesco, said the market is indeed vulnerable to a retreat at these high valuation levels—but not for long.

“Any pullback would likely be very short-lived given how accommodative Fed policy is,” Hooper said.

It’s a fresh reminder of the power of central banks. Easy money helped fuel a melt-up in stocks. And it could be enough to prevent a meltdown.