There are two big stories to watch in the stock market right now.
One involves the Federal Reserve…
…and the other involves Lyft, Uber, Pinterest, and other tech companies expected to complete initial public offerings (IPOs) in the near future.
First, let’s look at the Fed, which recently announced some changes in their outlook.
Story #1: The Fed
Just three months ago, their forecast indicated we should expect two more interest rate hikes before the end of 2019. Last week, that changed, and the forecast now is for no additional rate hikes this year.
That indicates the Fed believes the economy will slow, and their forecasts for economic growth confirmed that. GDP is now expected to grow 2.1% this year, a cut of 0.2% from the December forecast.
The Fed also announced changes to its plans for drawing down its balance sheet. During the financial crisis, the Fed’s balance sheet increased from less than $1 trillion to more than $4 trillion. In the past year, they have been selling off assets to bring the balance sheet down to a normal level.
They had been selling $50 billion worth of securities a month. Sales will now be reduced to just $35 billion a month in May, with a halt coming in September. These changes are designed to boost economic growth and are consistent with the Fed’s forecast for slow growth.
Notably, in bond markets, traders reacted by creating an inverted yield curve.
Normally, rates on long-term bonds are higher than rates on short-term debt. For example, you pay a higher interest rate on a five-year car loan than a three-year car loan. As the economy slows, the rates on Treasury securities inverts with rates on short-term Treasuries being higher than on long-term Treasuries.
Last Friday, the rate on six-month T-bills was 2.46%. The rate on five-year Treasuries was 2.24%, and the rate on 10-years was 2.44%. The curve is inverted from six months to 10 years, an indicator that a recession is likely.
Stock prices often fall during recessions, and the average bear market in a recession results in a loss of more than 30% in the S&P 500.
The Fed’s stance and the yield curve tell us that a stock market decline is likely.
Story #2: IPOs Could Be Sending A Bearish Message
The second big story — all those IPOs — is further confirmation of what the Fed and inverted yield curve have already told us… In short, that a large number of IPOs can signal a top.
There is an excellent paper by Kevin Lapham of Ned Davis Research that won the Charles H. Dow Award for 2009. It’s called, “Using IPOs to Identify Sector Opportunities,” which you can read here. In short, it suggests that a large number of IPOs could signal a peak in the market…
The theory behind the success of this indicator is twofold. First, investor sentiment can be gauged by the number of IPOs brought to market. Companies, venture capitalists, and investment banks will not benefit from the issuance of new shares unless there is ample investor interest in such an offering.
In studies by Norman G. Fosback, he stated “Companies sell stock to the public primarily when they need capital for expansion and related purposes. This usually occurs when business prospects are bright and companies view their stocks as generously priced by the market.”
This can only happen effectively when investor sentiment is bullish and stock prices have been rising.
Second, the number of IPOs provides a measure of supply and demand. Fosback also stated…
The new source of supply introduced into the market’s supply-demand equation also has the effect of diverting investment funds away from other stocks, thus exerting downward pressure on prices.
Since stocks in a sector typically move in concert with one another, a number of IPOs within the same sector that begin to falter due to lack of buying interest and excess supply will weigh on all stocks in that sector.
In that paper is an excellent and timely example showing the relationship between the tech sector IPOs and the tech-heavy NASDAQ 100 Index.
Source: “Using IPOs to Identify Sector Opportunities”
In the chart above, you can see that the number of IPOs and prices peaked at almost the same time. Lapham noted (emphasis mine)…
A clear example of investor exuberance related to a specific market sector is that associated with the Year 2000 tech bubble. In 1999, this sector outperformed all others with record momentum and an astounding 140% annual return.
An emerging internet/tech industry could not have existed without the huge investor appetite for shares of new issues. This unrestrained enthusiasm drove prices to unforeseen levels, resulting in one of the worst bubbles in decades.
The lower clip illustrates the spike in the number of technology IPOs per month in February 2000 (indicated by a down arrow). The solid line in the upper chart clip represents the NASDAQ-100 Index bubble top (indicated by an up arrow).
This is an unmistakable example of an increase in the number of IPOs correctly forecasting a bearish outcome which was realized after the year 2000.
What does all this mean?
Well, we could be seeing history repeat itself. Lyft’s IPO is expected this week. Pinterest and Uber are expected to complete IPOs in April. Later this year, the data mining company Palantir is expected to complete its IPO along with Airbnb, Rackspace, Slack, Robin Hood, Peloton, and Cloud Fare. These tech companies are valued at more than $200 billion.
It’s important to remember that IPOs involve early investors selling to the public. This could happen when the early investors believe that prices are likely to decline in the short term. It is unlikely the smart money behind these tech firms is attempting to redistribute income from the wealthy (which includes them) to the less wealthy (which includes us). It’s more likely the smart money is trying to get out at the top.
Action To Take
In other words, the Fed and Silicon Valley seem to agree that the stock market is ready for a decline. This echoes a theme I’ve been writing about for weeks now, and it’s also confirmed by momentum in major stock market averages.
In my opinion, now is the time to focus on preserving capital with conservative trades or the purchase of put options. That’s exactly what my Profit Amplifier readers and I are doing. In fact, we’ve placed a number of trades recently that could deliver significant gains when a stock moves up or down. And thanks to our strategy, we’re able to turn moves of just a few percentage points into gains of 10.4%, 58.9%, and even 60% or more in a matter of days.
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