It’s 2021 a year that comes after 2020 in which was subject to a mega crash due to a worldwide pandemic to a rally that baffled many, broke records, and seemed to only know one direction, up. Last year was a year in which virtually anyone, could buy anything at any time, and make money, but will the epic bull market that has boomed on for nearly 11 years continue to move higher?
At first look, the average person would shout “of course” sky is the limit, at the end of the day the economy has yet to recover from COVID-19 and 2021 could be euphoric for equities given the lack of surface issues plaguing the economy in 2021. I mean, I understand why people are bullish, the world is turning digital ushering in a technology boom, the COVID-19 vaccine is rolling out, interest rates are low, and the economy is set to roar back, at least according to the news.
While 2021 may seem great at first sight, the underlying multiples and patterns are far from bullish. Don’t get me wrong, we all love it when stocks go up but even the best of the best cannot go up forever. The mindset that you can buy a simple group of high growth names at any valuation and still make money has proven to end in disaster time and time again. By no means am I saying FAANG stocks or the high-flying technology sector is going to crash, but just because a company has 10 years of growth ahead of itself doesn’t justify purchasing at overdone multiples that are in some cases impossible to reach.
Just days ago the typical pundits on business news networks made the argument that the market was fairly priced, not overbought, even though the average price to earnings on the S&P 500 is at highs similar to the levels seen in 2000 and 2008, something we will get into later. While I am not a bear, I believe as an investor and trader it’s important to know with as much detail as possible the market you are investing in. Believe me, I am a bull, but even the biggest bulls need to know when to look at some facts and consider risks when making decisions. So take this report, not as fear-mongering, but simply some risks to be aware of when making your investment decisions, and this is coming from a trader who is bullish on the markets.
The Broadening Megaphone Top
Firstly we are going the technical route of things and for good reason, the chart typically tells a majority of the story. A megaphone top or “The Jaws of Death” is a pattern that forms typically at a top, finishing a huge run in the markets or an individual stock. In essence, a megaphone top is formed when an index or stock continues to make lower lows and even higher highs while the underlying indicators such as RSI, CCI, Volume, and MACD drop throughout the whole duration.
I am explaining this pattern to you because it seems it's currently forming on the Dow Jones Industrial Average. If we take a look at the SPDR Dow Jones Industrial Average ETF Trust, which follows the major index over the last 20 years, since 2017 a megaphone top has been forming. The market since 2017 has been forming lower lows, and higher highs, while maintaining an uptrend. This is great on the surface, the market has had huge opportunities, but since then the RSI, CCI, MACD, and volume have all been declining.
Now your probably asking, well has this pattern been proven to precede a crash? Well, in fact it has, the megaphone top pattern has preceded market crashes in 1929, 1957, 1965-1966, 1972-1973, 1986, 1998-2000, and 2004-2008. All of which were major crashes that led the markets lower after massive bull runs. Below are charts of each event, with the megaphone top pattern charted.
All charts sourced from (https://www.marketoracle.co.uk/Article5623.html).
While the megaphone top pattern does not have to result in a crash, historically it has and it’s just one of the risks to have on your mind. The market can keep moving higher, by no means am I saying it can’t. At the end of the day, the market doesn’t follow historical patterns all the time. On the otherhand, the resemblance between this pattern from 2017 to the present is a near-perfect match to what has happened time and time again in the past.
Now, I am sure you have heard this argument. New traders and many advanced as well, are using margin power like never before and it could be dangerous. While margin is a useful tool, it indeed can be dangerous, and in many cases, margin debt highs or parabolic increases have preceded major crashes.
For example, in 1999 margin debt soared to record levels and just a few months later the S&P 500 topped out and crashed faster than anyone could have imagined. Then in 2007 margin debt went on another parabolic run and topped out, preceding the great financial crisis that came just three months later.
Below is a chart that shows the relationship between margin debt and the S&P 500 from 1997 to 2021.
While this is a shorter-term indicator and pattern and is not an insanely reliable indicator of a market crash, it’s definitely a risk to take into account. Twice now, a margin debt peak has implied a crash shortly after, but that does not mean it has to happen a third time.
For more on this subject, I suggest checking out the link below. It is a very in-depth article from the AdvisorPerspective, which digs not only into this potential margin debt pattern but credit balance data in which has also shown a similar pattern.
Next up is corporate profits and the relationship between corporate profits and the S&P 500. Throughout the years the relationship has proven to show and maintain a very telling pattern. Historically, when the market’s gains diverge from the after-tax profits of corporations, the market has a higher rate of correcting.
Unfortunately, the market in recent years has been led to think corporate profits are growing, but in reality, the numbers are usually manipulated and corporate profits after tax have been flat since roughly 2012. Not only that, but the real profits of major companies are not supporting or in essence confirming the major rally seen in recent years.
Below are two charts from Real Investment Advice that show the relationship between corporate profits and the S&P 500 since 1970.
A link to the Real Investment Advice website is below. I recommend you check it out as it goes into how corporate reports are manipulated and what corporate profits have actually been doing in recent years.
The Buffett Indicator and P/E Ratio
Let’s start with the Buffett Indicator. The Buffett Indicator has been a favorite of many including the man himself for many years. The Buffett Indicator is a ratio between the total US stock market valuation and GDP.
Just before the 2000 “Dot Com” crash, the Buffett Indicator topped out at 71% which represents according to its scale a strongly overbought market, a gigantic number at the time, that then led to one of the fastest and most well-known crashes on Wall Street in recent memory. Well, it shouldn’t shock you that the Buffett Indicator hit 76% on December 30th, a level not seen since the infamous year of 2000.
It is also worth noting, that prior to the market crashes in the mid-1960s and early 1970s the Buffett Indicator topped out as well at levels deemed Over Valued on the indicators scale.
Below is a chart of the Buffett Indicator since 1950, the resemblance between now and then is shocking in my opinion.
This chart is from; http://www.currentmarketvaluation.com/models/buffett-indicator.php
Now don’t get me wrong, it’s one indicator and one crash, there is definitely not yet a long time pattern here, but I believe it is worth taking into account that such a major indicator such as the Buffett Indicator has reached levels not seen since one of the most recent crashes that devastated many on Wall Street.
On a final note, it’s also important to compare the Buffett Indicator to Treasury Bond Rates. While this may seem odd, the pattern created by the comparison could be a warning to investors.
Below is a chart from Current Market Valuation, a website I highly recommend checking out, as it draws solid patterns between the Buffett Indicator and Treasury Bond Rates.
This chart is from; http://www.currentmarketvaluation.com/models/buffett-indicator.php
In this chart, the divergence between the Buffett Indicator and Treasury Bond Rates is greater than both the historical divergence in the early 1980s and 2000, both of which preceded major market crashes.
Shifting into valuation, as I noted earlier the market is trading at sky-high valuations when compared to past data. In fact, the S&P is currently trading at roughly 37.29x, a level not seen since 2000 and 2008.
Although, the Price to Earnings itself must be taken with a grain of salt, given that average P/E peaks have not always correlated with massive drops in the markets. Below is a chart showing the S&P 500 P/E ratio since 1880, hopefully, you can draw some patterns from it.
Chart from; https://www.multpl.com/s-p-500-pe-ratio
Overall, valuations are at near-record levels and one must ask the question as to how much longer the market can maintain these levels going into 2021.
Another issue not many are talking about in 2021 is the large expectation that the dollar could crash in 2021. Unfortunately, the US government has continued to spend and the US debt has reached roughly $27 trillion, on track to top $30 trillion soon. Not only that, but the Fed continues to print, diminishing the dollar when interest rates are historically very low and congress continues to pass stimulus bills that borrow an immense amount of money.
In fact, just a few weeks ago, ING chief economist Carsten Brzeski said “We forecast another 5-10% dollar decline through 2021 as the Fed allows the U.S economy to run hot,” (cnbc.com).
It’s not just a few economists either. Economist Stephen Roach warned of a double-dip recession in November, just a few months ago and noted that “This is just the early stages” to the decline in the dollar. He went on to tell the reporter that his base case targets a 35% decline in the dollar between the time he spoke and the end of 2021 (cnbc.com).
Economist Peter Schiff also noted that the dollar is in for great declines in 2021 as well, noting “The U.S. dollar is now trading at its lowest level against the Swiss franc since Jan. of 2015. This is a harbinger of things to come. The franc is leading the way, but other currencies will soon follow. 2021 may be the worst year ever for the U.S. dollar, at least until 2022,” he tweeted on December 2nd (bitcoin.com).
Then at Reuters annual investment conference in early December, BlackRock’s chief investment officer Rick Reider said “The markets are right, I think the dollar will cheapen from here,” (bitcoin.com).
Not only that but Citi Bank is forecasting a 20% decline in the dollar by the end of 2021. If the dollar crash does occur, investors must prepare. Looking back when the dollar weakens the international stocks typically due much better, which could imply why names such as $EEM saw huge year-end runs in 2020. Below is a chart showing the relationship between the dollar and market returns.
Another sector that could see a bounce if the dollar crashes is gold. Typically as the dollar declines the price of gold increases, as it is typically bought in situations where an investor wants to reduce risk from an impending potential crash. Below is a chart representing the relationship between Gold and the dollar.
Overall, a declining dollar is not necessarily good for the stock market but there are ways to play it and profit from its decline. This is once again another risk that investors must be aware of in 2021, as the dollar is a major aspect of the US economy.
Buffett and Munger
My final point is less a risk and more analysis. Warren Buffett is known as the best investor of all time, and he has weathered nearly every major market crash but in the COVID-19 crash and throughout the year, Buffett did something rather odd, he became a net seller, not a net buyer.
In fact, throughout the huge rally in 2020 Buffett sold Occidental Petroleum, Restaurant Brands International, all of his airline holdings, and parts of his mining and bank names. Throughout the year his only buys included his own Berkshire Hathaway, Barrick Gold, his fund invested in five major Japanese companies, and let’s add Berkshire’s huge amount of cash.
Given this, it seems Buffett is bearish in 2021, entering with a position in gold and betting on foreign companies, which as we noted earlier tend to do well when the dollar crashes. Now this is all simply speculation and Buffett still has massive holdings in big growth names such as Apple, but his recent moves imply he is more bearish than bullish in my opinion.
Finally, Buffets righthand man, Charlie Munger recently warned about a bubble and huge market crash just a few weeks ago. How this didn’t hit the headlines is beyond me. Munger noted recently that he expects investors to achieve much less return than in the last decade going forward and is very unnerved by the market action. In fact, in a recent interview, he said “We’re very near the edge of playing with fire.” (fool.com).
Overall, it’s important to note that even the greatest investors in modern times are warning of a potential drop in the markets.
My Conclusion Given All This Data
In short, I am considering all of these risks going into 2021, and believe a more conservative investment strategy should be considered. I am a bull and do believe the market will continue to move higher on a long term basis, but the chances of a crash in the market alone are enough for me to be more cautious than I was in 2020.
Now, there are other factors I did not cover in this report, as they are still in process. Other worries I have in 2021 include both government tax policy which could change with the Democrat’s chances of taking the Senate, and a housing market crash in late 2021 or 2022, as many predict, but a housing crash is near impossible to time, so it didn’t make my high risk list.
Going into 2021, I urge caution but not bearish sentiment. I simply recommend that investors become more disciplined, take profits when they have them, and cut losses short, the basis of most successful investors. I am no genius but I have learned to spot patterns, and the several patterns that I have gone through in this article are a worry to me going forward in 2021.