Why The “Smart” Money Is Preparing For A Bear Market…

This week, I want to address two important points that I’ve been hearing a lot about lately — IPOs and earnings. 

First, I want to note that the initial public offering (IPO) market is operating exactly as it’s designed to. It’s shifting money to a group of investors that can be considered the “smart” money. 

In the past few weeks, we have seen large offerings from Lyft (Nasdaq: LYFT), Pinterest (NYSE: PINS) and Zoom Video Communications (Nasdaq: ZM). All three have transferred wealth from individual investors to some of Wall Street’s largest players. 

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I wrote about Lyft in this recent article. The stock ended last week about 22% below the level where it opened on its first day of trading. 

LYFT chart

The next two big tech IPOs came last Thursday, and the pattern appears to be repeating. 

PINS officially gained 28.4% on its first day, but the closing price was just 2.7% above the open. Most individual investors who bought that day made little, if any, money. ZM ended its first day with an official gain of 72.2%, although the close was 4.6% below the open. It’s almost certain that most individuals who bought the stock that day show a loss instead of a large gain. 

This is all consistent with the typical pattern of IPOs: 

– Going public unlocks wealth for early investors in the company, including Silicon Valley-based venture capital (VC) funds.
– The VC’s shares are being allocated to large investors including hedge funds and other investors who generate large fees for the firm handling the IPOs.
– Individual investors trying to participate in the IPO are buying shares from the hedge funds, allowing those funds to lock in large gains on the first day of trading. 

Based on the price action we’re seeing so far, IPOs are redistributing wealth from individual investors to professionals on Wall Street and in Silicon Valley. That’s exactly what I expected, but it’s a cause of concern for the broad stock market. As I’ve discussed recently, I’m watching the Nasdaq 100 Index for a signal that the rush of IPOs is set to trigger a bear market. 

For now, the index remains bullish. That means I don’t expect a sharp decline this week. This market is likely to turn suddenly, and I am preparing for that possibility. As I look at what to expect after the break occurs, I’m increasingly pessimistic about the longer term. 

The data is confirming that these IPOs (and the ones that will follow in the coming weeks) are a sign of a speculative market — one that’s trading based on hope rather than fundamentals. 

Speaking of Fundamentals
Fundamentals are generally weak, as the initial group of earnings reports confirmed. According to FactSet, 15% of the companies in the S&P 500 had delivered earnings for the first quarter of the year (as of Thursday). 

#-ad_banner-#I’m going to summarize the results with bullets because there are a lot of numbers: 

– 78% beat earnings per share (EPS) estimates. This is above the one-year average (76%) and five-year average (72%). 
– EPS reports are 5.7% above expectations, on average. This is equal to the one-year average (5.7%) and above the five-year average (4.8%). 
– 53% beat revenue expectations. This is below the one-year average (67%) and five-year average (59%). 
– Sales are 0.4% above expectations. This is below the one-year average (1.4%) and five-year average (0.8%). 

I showed the one-year and five-year averages for context. You can see that earnings beats are higher than average. Both the number of companies reporting better-than-expected earnings and the size of the beats are impressive. Meanwhile, revenue beats are below average with both the number of companies beating expectations and the size of the beats showing cause for concern. 

My concern is related to the fact that management has a strong impact on EPS. Companies can boost EPS by buying back shares, by capitalizing rather than expensing equipment, by using longer deprecation periods for equipment, and in a variety of other ways. 

I am not saying companies do this deliberately to manipulate earnings. What I’m saying is that earnings are unavoidably manipulated by decisions made in the ordinary course of business. 

Revenue is more resistant to management’s influence. As such, it provides a more accurate picture of growth. In the few reports we have so far, the trend in sales is not nearly as optimistic as the trend in earnings. It’s too early to say this is a strong bearish signal, but it’s something I will update throughout earnings season. 

Small Caps Looking Weak
Another indicator of market weakness is the performance of iShares Russell 2000 ETF (NYSE: IWM). The Russell 2000 is an index of small-cap stocks, which tend to outperform large caps in a healthy bull market where investors seek out risk and bid up the price of small-cap stocks. 

That’s not what I see in the next chart. 

Russell 2000 chart

​My Profit Amplifier Momentum (PAM) indicator is shown at the bottom. The 40-week moving average (MA) is also shown as the solid blue line. Right now, both of those indicators are bullish. 

PAM remains bearish and IWM is facing resistance at the 40-week MA. This chart shows that investors have not been buying indiscriminately in the rally that began in December. Rather than buying risky assets, they have been putting cash into safer large-cap stocks. 

Action To Take
To bring this all together, the market action is indicating that the smart money is preparing for a bear market. VC funds in Silicon Valley are taking profits rather than hanging onto their shares to reap bigger profits later. 

Earnings reports indicate the business cycle is turning down. Earnings are being created by accounting departments rather than operations. That can’t last for long. 

Long-term investors seem to be sitting on the sidelines despite the market rally. If they believed the selloff in the fourth quarter of last year created value, we would be seeing new highs in the IWM small-cap index. 

There are many reasons to be cautious in the current stock market. But the most important indicator is the price action and the fact that many stocks are in “up” trends. That will be the focus of my investments in the coming weeks until we see a reversal in the large-cap indexes. When we see that reversal, I expect the bear market to be quick and deep — and we’ll be prepared for that, too. (To see how, read this report…)

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