Is A Third Wave Coming?

Posted: Feb. 26, 2018, 10:53 a.m. by

Third Wave

A recent poll of 500 institutional investors suggests that despite the rally, the market may very well see a decline of between 10% and 15% sometime this year. One reason for this bearish attitude has to do with the fact that large stock market selloffs tend to come in 3 waves. So far there have been two.


Two Down One To Go

Chris Watling, CEO of Longview Economics suggests that the market has already gone through two waves typical of this pattern. The first, he says, was the 10.2% correction in the S&P 500 from the close Jan. 26 through the close Feb. 8. After that came the second wave or as Watling calls it, a "relief rally."

That leaves a potential third wave that could either hit new lows or test the lows of the first wave of the sell-off. What it all boils down to is a climate with some more downside risk over the next few weeks, according to Watling.

Those High Valuations

Historically high stock market valuations are a concern. They bring, with them, the prospect of a tremendous setback for stock prices. Further, the Shiller CAPE ratio which measures stock valuations is at its highest level ever (not counting the Dotcom Bubble in the late 1990s).

A decline in the forward P/E ratio for the S&P 500 has partly been the result of recent stock price corrections and partly due to rapidly increasing corporate earnings forecasts by Wall Street analysts.

Potential Misconception

But maybe the entire third wave theory is wrong this time. It all hinges on whether rising Treasury yields are bad news for stocks. One analyst says, “Not so fast.” While it’s true Treasury yields are new multiyear highs of 3% for 10-year certificates, Oppenheimer technician, Ari Wald says history shows that rising rates are bullish for the stock market.

According to Wald the direction of interest rates is equally or more important than the level of rates. Low and rising, he says, is bullish for stocks. High and falling is bearish. Wald points to a chart of the 10-year yield and the S&P 500 going back to 2000. Over that period, he says falling interest rates have coincided with a drop in the market. Rising rates, on the other hand, coincide with growth coming back into the market, according to the analyst.


Sectors Matter

Wald says that investors looking to put money to work should consider cyclical sectors like financials. Further, he cautions against so-called bond proxies like utilities, telecom and real estate investment trusts which he says will “get hammered” in the current environment.

Others like Boris Schlossberg, managing director of FX strategy at BK Asset Management, believe the rate rally could still pose a threat to stocks. "We could be in a situation where rates are rising because of deficit financing, we could be in stagflation," he said adding, "That is in no way positive for stocks, so I remain highly dubious that rising rates are actually positive for stocks unless we have 3 to 4 percent growth."