The Tell: Stock-market investors are careening ‘ever closer to the sun’, warns strategist

Is the stock market starting to exhibit signs of strain, after a mostly unceasing climb into the ionosphere?

That is the question at hand for many market participants as Wall Street awaits progress on tax-cut legislation, absent further drivers for the Dow Jones Industrial Average DJIA, -0.13% the S&P 500 index SPX, -0.23%  and the Nasdaq Composite Index COMP, -0.29% to carve out fresh all-time highs.

Fears of an impending market downturn have dogged stock-market bulls for weeks because valuations for equity gauges, by some measures, are stretched, or at their highest level in recent memory, and popular measures of volatility, notably the CBOE Volatility Index VIX, +0.09%  have been all-too quiet.

The fact that investors are wringing their hands over the prospect of an equity downdraft may serve as a sign that the market isn’t growing too euphoric or complacent, but that doesn’t mean market participants aren’t duly cautious about being ill-prepared to get knocked lower.

Here are a few things investors are paying attention to:

Valuations

A record-high 48% of investors surveyed by Bank of America Merrill Lynch think that stocks are overvalued, according to the banks report dated Nov. 14. The reading led BAML’s chief market strategist Michael Hartnett to declare that such a reading implies stocks may be due for a pullback.

“Icarus is flying ever closer to the sun,” Hartnett said “and investors’ risk-taking has hit an all-time high. A record high percentage of investors say equities are overvalued yet cash levels are simultaneously falling (as the chart above indicates) is an ominous sign.

Volatility

The aforementioned reading of volatility, the CBOE Volatility Index, otherwise known as VIX, has been tipping gradually higher in recent trade. The gauge, based on options activity, measures expectations for S&P 500 volatility over the coming 30 days. Because stocks fall faster than they rise, it is often viewed as a measure of expectations for a market downturn.

The measure of implied volatility has is up 16% so far in November, compared with the Dow, S&P 500 and the Nasdaq which are roughly flat on the month. The VIX tends to move inversely to stocks, rising as stocks fall.

To be sure, the VIX is far beneath its historical average at around 19, and because it has carved out historic lows as equities have rallied to records, it is easier for the gauge to reflect a sharp move up.

Russell 2000 index break down

The small-cap oriented Russell 2000 index RUT, -0.26%  has been lagging behind its larger-cap brethren, slipping below its 50-day moving average earlier in November. Small-cap stocks are watched for signs of confirmation that a broader uptrend, moving beyond just industry giants like Apple Inc., AAPL, -1.51%  for example, is at hand. A breakdown in small-caps implies that market sentiment may be waning somewhat, particularly as concerns about pro-business changes to tax policy happening soon grow. Smaller companies tend to benefit the most from changes to corporate tax legislations.

Utilities in record territory

The utility sector, considered a defensive sector where investors tend to park money in the face of worrisome markets, have been hitting historic highs and continue to outpace other sectors.

Indeed, utilities have climbed 2.8% so far in November, compared with a 0.7% rise for the technology sector, according to FactSet data. That climb has come even as the likelihood for a rate increase by the Federal Reserve once more before year-end has grown. The dividend yield of the utilities sector is 3.4%—highest among the S&P 500’s 11 sectors—and richer than the 2.40% yield being offered by 10-year benchmark Treasury note TMUBMUSD10Y, -1.37% and the roughly 2.8% yield of the 30-year Treasury bond TMUBMUSD30Y, -1.54%

Defensive sectors climb

Other so-called defensive sectors viewed as less risky and yield bearing have performed well in November. Real estate has gained 4.1% month-to-date, while consumer staples are up 3.2% and utilities have gained 2.8% [see indexed chart below with real estate (pink), consumer stables (brown), utilities (red)]:

Junk-bond tumble

Wall Street bears have been sounding alarms about a recent drop in non-investment-grade bonds, popularly referred to as junk bonds. The SPDR Bloomberg Barclays High Yield Bond ETF JNK, -0.38% an exchange-traded fund that tracks junk bonds has been down nine of the past 10 sessions, raising concerns for investors about risk appetite in the market.

To be sure, the market has defied a number of cautionary signals, that failed to accurately herald that a downturn in the market. That includes in August when small-caps, the VIX, a rally in gold GCZ7, +0.12%  futures all suggested that equities were potentially headed for a substantial pullback.

That retreat never happened and maybe it won’t happen this time either. But professional investors are getting antsy again.

“Even though we are near all-time highs, the nervousness in the market for investors who remain long is palpable,” J.J. Kinahan, chief strategist at TD Ameritrade, told MarketWatch.

All that said, one big upside to a market downturn may be cheaper stocks.

Read: Elevated CAPE ratio suggests stock market returns to decline, regional Fed bank finds

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