Multiple Contractions Loom for SPY and DIA

A few weeks ago I was discussing the short covering rally that led up to memorial day, and in doing so discussed the odd market environment that often surrounds that holiday.  The short covering rally was only part of it, but it was crystal clear that shorts were increasing aggressively the week before Memorial Day.  The markets were increasing aggressively on news that did not seem to be that positive, and it was doing so on the heels of a decline that happened just prior.

The stage was clearly set for a short covering rally, but what happened afterwards was confusing to many smaller investors.  After short covering rally stake place and an extended weekend comes and goes those investors who got out of short positions have a decision to make.  They could either reengage their positions when they returned from the extended holiday, or wait a while and let the markets press higher, if they are perceived to do so.

After this past memorial day, the selling pressure absolutely subsided, as they waited.

I pointed this out numerous times, but the rally that existed after memorial day, and leading up to last Wednesday, was on extremely light volume, and only when selling pressure hit the market did volume levels appear more normal again.  The conclusion, although we cannot be certain, is that smaller investors were bidding the market up and institutional investors were simply sitting back and waiting for the market to get to a level at which they determined it would be okay to start selling again.

This was the warning that I was relaying, it suggested that institutional investors were poised to sell into this rally again, but they were just waiting for the opportune time to do so.  With the S&P 500 coming very close to 2127, our longer term resistance level, and the other markets doing the same, the close proximity of longer-term technical resistance and concerning news from the bond market were reason enough for institutional investors to start selling into the rally again last week.

The question is, how long will this last?

My observations tell me that the cash to margin debt ratio on the New York Stock Exchange is hovering around all-time lows, institutional investors are not capable of adding significant amounts of margin debt to support this market, and instead they are more likely to reduce their exposure to margin debt if they’re given the opportunity or if they are forced to.  That means, based on my observations, institutional investors are far more likely to sell than they are to buy this market.

Recent concerning words from Goldman Sachs, JP Morgan, and UBS would support my observation as well, so I am not the only analyst telling you that stocks look risky.

However, I may be the only analyst telling you that nothing materially needs to change in the business environment for this market to fall by 40%.  Based on a horrid growth rate in both the dow Jones industrial average and S&P 500, which includes forward looking observations, the current PE multiples levied on the S&P 500 and dow Jones industrial average set them up for multiple contractions and those can happen without any hiccups to current business cycles. 

PE for Market Based ETFs:

  • SPDR S&P 500 ETF Trust (NYSEARCA:SPY) : 19x
  • SPDR Dow Jones Industrial Average ETF (NYSEARCA:DIA) : 17x

Multiple contractions, just like multiple expansions, occur based on simple supply and demand.

I have told you that the likelihood for institutional selling pressure is high given the low cash to margin debt ratio, but based on my macroeconomic assessments the natural demand for new investments in the United States, which includes stocks and real estate by the way, is declining in a way that is very similar to the Great Depression and stagflation.

Not only do we have reduced demand, but we have increased supply, and that’s a double whammy.  Simple multiple contractions can take this market down by 40%, but markets have a tendency to overshoot and undershoot so beware that it may get uglier than that.

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