Apparently, no one sent the market memo to the S&P 500 until last week when investors woke up to the prospect of “stretched” valuations after months of warnings from US Federal Reserve Chairwoman Janet Yellen. Last Friday’s substantial losses come on the heels of global equity losses to which US benchmarks are not immune, but the shift in sentiment fails to unearth the true fundamentals of the S&P 500 Index which has seen the valuation largely intact despite contracting constituent revenue growth and broader softness in the US economy. Although the index is not trading far from all-time record highs, a return to those levels seems implausible considering the current earnings environment.

The Fundamental Picture

Central banks operating at or near the zero bound for the years subsequent to the last financial crisis have in many ways stimulated investment behavior, channeling asset flows towards higher yielding financial instruments. Evidence of this phenomenon is no clearer than the steep rebound in equity indices following the last downturn. Investors hunting for yields were forced to move away from bonds, which produced little to no returns thanks to low interest rates, towards stocks which offered more attractive returns but with increased risk. During quantitative easing, the liquidity that flooded the market was promptly funneled in the same direction, stocks, helping to boost asset valuations with indices soaring to near record highs. However, much of the gains were built on the back of interest rate policies, not by companies building the top and bottom and lines.

One of the most prominent changes in behavior came from corporations. Due to the challenges of consumer deleveraging and a softer economic outlook, companies shifted from production to cost cutting and buyback measures to boost the bottom line. By laying off workers and pruning expenses down to the bone, companies were able to find substantial savings. Interest rates at record lows made corporate borrowing extremely attractive, with companies choosing to borrow in the public markets to fund buybacks of outstanding shares. While soaking up the available inventory of shares, corporations were able to effectively raise earnings per share by reducing outstanding shares with minimal efforts towards growing revenues organically. However, with interest rate normalization lingering just around the corner, corporations that have postponed capital expenditures and investment projects are now struggling to find ways to grow the top line and satisfy analysis.

With current valuations for companies at sky high levels, the room for momentum lower is substantial in equities. According to the latest estimates, full-year revenues are expected to contract for the aggregate S&P 500 index for the first time since the last financial crisis. Revenue shrinkage in quarter one is expected to be largely outpaced by results in the second quarter, adding to the downside case in equities. In order to protect the bottom line, companies are likely to pullback the reins on investment even further, coupled with another round of layoffs to slash expenses. When coupled with an expensive dollar, slower growth in the United States, and looming headwinds from Europe and Asia, the case for more upside is limited at best.  With the current price-to-earnings at just a hair over 20 versus longer-term averages near 15, the worst place an investor can be in the current investing environment is chasing after another 3-5% of upside at the risk of a 15-20% downside correction from current levels. 

The Technical Take

The bearish fundamental case prompts a closer look at the longer-term technical considerations for a clear big picture analysis of the future for the S&P 500 index. Since February, the index has been trading within a very narrow range between resistance at 2134 and support at 2035, nearly a 100 point distance. In fact, a closer look shows that the Dow Jones Industrial Average valuation which is closely mirrored by the S&P 500 very accurately tracks growth in the Federal Reserve’s balance sheet as shown below.  With no more quantitative easing and monetary stimulus, stocks are languishing with no other buyers of last result.  As the balance sheet shrinks, so too will stocks follow the path of the Central Bank’s policies.

A look at the charts displays almost no prominent patterns after the index trended relatively sideways for months on end.  With the S&P 500 currently trending below both the 50-day and 200-day moving averages, the indicators are mainly negative towards the outlook. However, with the RSI rapidly approaching the oversold area of the indicator, it could mean potential for a near-term technical rebound after 5-straight losing sessions. Nevertheless, momentum is already leaning towards the downside as evidenced by the stark losses across Asia and Europe today. The major target on the downside remains support at 2035 based on the existing longer-term range. If viewed from 1-day candlesticks, the chart also resembles a head and shoulders bearish formation, an additional downward bias. This would imply any move below critical support at 2035 as a downside breakout to be accompanied by renewed volume and momentum.

Conclusion

The carnage in equities is unlikely to abate anytime soon as evidenced by today’s momentum lower across the globe which when coupled with the increase in volatility sees investor sentiment sour over time. The S&P 500 is overvalued by many measures and with Central Bank support rapidly coming to a conclusion, the case for further upside is limited at best. With revenue growth set to falter and technicals lining up a case to the downside, the S&P 500’s next stop looks to be the critical support level at 2035 as the market gets the slowing growth memo.