I’ve been expecting a pullback in the stock market — and we saw one. Last week, we saw momentum beginning to wane. This week, it shows signs of recovering.

Stochastics — the popular momentum indicator shown at the bottom of the chart below — has turned back up.

The blue rectangle highlights the 50% to 61.8% retracement levels. Prices are holding within that range, but they are positioned for an upside breakout. (You can read more about retracements here.)

The upper blue line shows the potential upside of a rally is significant. It’s a channel line based on the lower trend line.

The fact that momentum turned up this week is surprising given the news. Unemployment was “off the charts” according to The New York Times, which had a dramatic image on its front page.

(A personal thought: For those saying newspapers have no future, this is an example of the power of the printed papers. An image like that would be difficult to reproduce on a web page. That also shows how unusual the current period is.)

Details of the unemployment report are equally dramatic. Job losses totaled 20.5 million as the unemployment rate jumped to 14.7%, the highest since the Great Depression. Unemployment reached about 25% in 1933, before the government began publishing official statistics.

Just 51.3% of the adult population had a job, the lowest on record and down from 61.1% in February.

“I thought the Great Recession was once in a lifetime, but this is much worse,” Beth Ann Bovino, chief U.S. economist at S&P Global, told The Times.

Based on this, and other economic news, we know the data doesn’t explain the strength of the stock market.

What About Earnings?

We also know that earnings don’t explain the strength.

With 86% of the S&P 500 already reporting results for the first quarter, earnings look like they will be down 13.6% compared to the first quarter of 2019. This will be the worst quarter since the third quarter of 2009, when earnings were down 15.7%. This will also be the fourth time in the past five quarters in which earnings dropped on a year-over-year basis.

Investors are pricing in a rapid recovery in earnings. Based on expected earnings, the price-to-earnings (P/E) ratio for the S&P is 20.4. That’s above the five-year (16.7%), 10-year (15.1%), 15-year (14.6%), and 20-year (15.4%) averages.

While stocks appear to be overvalued, there is some good news in the fact that they could become more overvalued. The highest P/E ratio based on expected earnings over the past 20 years was 23.4, reached on September 1, 2000. The dashed line in the chart below shows that peak.

The peak in the P/E ratio came during the bear market. Investors didn’t know it in September 2000, but the S&P 500 had already peaked in March. The top in the P/E ratio coincided with the top of the first bear market rally.

That was an example of investors disregarding the fundamentals. That could be happening again.

What About Buffett?

Not all investors are ignoring fundamentals. Warren Buffett held his annual meeting last week and noted that he was not a buyer in the decline. In fact, he was a seller.

Buffett told investors that during the selloff, he sold all of his airline stocks, a $4 billion stake that included positions in United, American, Southwest, and Delta Air Lines.

He noted that, “the world has changed for the airlines. And I don’t know how it’s changed and I hope it corrects itself in a reasonably prompt way. I don’t know if Americans have now changed their habits or will change their habits because of the extended period.”

“I think there are certain industries, and unfortunately, I think that the airline industry, among others, are really hurt by a forced shutdown by events that are far beyond our control.”

In clear words, he stated, “Our airlines position was a mistake.”

Buffett is clearly the “smart money” in the stock market, as evidenced by his amazing long-term track record. We know that he was selling. Someone had to be on the other side of that trade. Many of the investors buying airlines were individual investors.

One ETF, the US Global JETS ETF, grew from about $50 million to almost $600 million in assets as investors poured money into the fund.

JETS saw its assets increase to as high as $615.8 million on April 30, from $34.6 million on March 3, representing an increase of more than 1,600%. Some of that increase came from investors at Robinhood.

On March 3, just 386 Robinhood accounts owned JETS. Today, more than 20,000 do, representing an increase of more than 5,000%. The chart below shows the surge in buying came as prices fell and (as we later learned) at the same time Buffett was selling.

Source: Business Insider

Over his career, we have learned that Buffett can be wrong. But we also have learned that it’s not a good idea to bet against him.

Closing Thoughts

We know that Buffett is not seeing long-term buys in the current market. Prices could move higher from here, but this is a market for short-term traders. Long-term investors should consider following Buffett’s lead and waiting for better opportunities.

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