The 4 main drivers of market strength are all past their prime - and it's leaving stocks vulnerable to the next big crash
- For years, the stock market has benefited from a remarkable confluence of positive factors, which pushed it to record highs.
- One Wall Street expert says these catalysts appear past their prime, which could lead to selling in the US market that would put the October correction to shame.
Through the first nine months of 2018, everything was firing on all cylinders for the US stock market.
Companies were big beneficiaries of President Donald Trump's unprecedented tax cuts. Year-over-year earnings growth was in the double digits. Firms were repurchasing record amounts of their own stock. And passive investors were seemingly buying everything in sight.
Looking back at this remarkable confluence of positive factors, the market's Red October shouldn't be much of a surprise. After all, it's when conditions peak to such an extent that stocks are the most vulnerable.
Vincent Deluard, a macro strategist at INTL FCStone, is firmly in the camp of experts who say US stocks are past their prime. In a recent note to clients, he went into detail around each of the four equity drivers listed above, showing how each one is on the downslope.
When viewed together, his arguments paint a stark picture for a stock market that spent a long, blissful stretch priced for protection while enjoying a historically low-volatility environment.
Now that there are cracks forming in that stable veneer, a swift comeuppance may be in the cards - one that could put the October correction to shame.
Here's a breakdown of Deluard's four past-their-prime stock catalysts:
1) Tax cuts
The reasoning here is straightforward: The boost companies got to their bottom lines is not going to last forever. And next year, when it comes time to compare profits to the same period in 2018, the trend will be going in the wrong direction.
A reversal of the positive effects driven by tax reform could come even sooner. Deluard points out that if Democrats regain control of Congress in the midterm election, they could try to undo the tax law. This would be a major negative for equities.
2) Monster earnings growth
This is another situation where there's really nowhere to go but down. The 25.5% earnings growth enjoyed by S&P 500 stocks in the second quarter was the peak, says Deluard.
Analysts expect profit growth to slow all the way to 10% next year - and even that figure is quite generous, he says. Considering earnings expansion has been the foremost driver of equity gains throughout the nearly 10-year bull market, this trend reversal is troubling.
Further, Deluard warns that analysts are behind the eight ball, and will need to revise their 2019 estimates lower at some point.
3) Share buybacks
Share buybacks have been the backbone of the bull market for the past nine years and change. They've provided a safety net for stocks during times devoid of other positive catalysts.
They also surged to $200 billion in the second quarter, which spurred analysts to forecast a record $1 trillion in repurchases for full-year 2018. This is yet another dynamic that looks like it's peaked.
"Close to a third of U.S. companies pay more in buybacks and dividends than they earn, which is unsustainable by definition," said Deluard, who also provided the chart below.
4) Demand from passive investors
Out of the peaking drivers listed here, Deluard is the least convinced about this one. Still, he notes that US equity ETFs saw seven consecutive days of outflows between Oct. 5 and Oct. 16 - in the throes of the big stock sell-off.
While he thinks this sort of behavior can continue during times of market stress, he's most worried about what peaking passive investment will mean for near-term stock price fluctuations.
"A decade of price-insensitive buying may have pushed the valuations of 'ETF darlings' so much that they might be more vulnerable to sudden corrections," said Deluard.
