'Tinderbox’: Why one strategist says a market flare-up is ahead

High valuations, low volatility and poor seasonal trends point to serious trouble ahead for stocks, according to macro strategist Boris Schlossberg of BK Asset Management.

Though it has come off a bit from recent highs, the S&P 500's forward price-earnings ratio continues to be at very elevated levels within a historical context. Investors are currently paying 17.4 times the earnings that are expected over the next year, according to FactSet data; that compares with an average of 14.1 times over the past 10 years.

While valuation is a notoriously poor short-term indicator, investors often use it as a clue about the market outlook. The prevailing perspective is that when valuations are high, sentiment either has to go from positive to euphoric in order for stocks to go higher — that, or actual earnings have to take a surprisingly sharp upward trajectory.

Another concern for Schlossberg is a general absence of market anxiety. He points out that the CBOE Volatility Index (or the VIX) continues to trade at moribund levels.

"Investors have been incredibly complacent," Schlossberg said Tuesday on CNBC's "Trading Nation."

Of course, it might also be pointed out that stocks have been incredibly quiet, so demand for S&P 500 options — which is what the VIX roughly tracks — has been lacking. But in a way, the market stability is simply another symptom of the general lack of fear among investors.

Schlossberg thinks this condition is unlikely to last. He points out that equity volatility tends to increase in the fall. Additionally, he notes the somewhat odd coincidence that in years ending in "7," a drop of at least 5 percent has tended to be seen in September and October.

When the strategist puts it all together, he concludes that the prognosis is not good.

"Given the context of high valuations, in typically a very, very tough time for stocks, when we have volatility really starting to spike in the fall — all of those things just create a tinderbox for a potential storm for investors," Schlossberg said.

"We've all been talking ad nauseam about the low VIX and how every dip has been a buy," he said. "That's one of the most dangerous things that's been happening in the markets right now, because investors have completely convinced themselves that every dip is a buy, and, eventually, as we all know, one of those dips begins to fail."

That failed dip "may be the one that we could be seeing in the next couple months," Schlossberg added. "I definitely think that we could see a 5 to 7 percent decline in equities."

Chad Morganlander, a portfolio manager at Washington Crossing Advisors, strikes a similarly cautious tone.

"In our portfolios, we reduced risk," Morganlander said Tuesday on "Trading Nation." "Valuations we believe are stretched, and it seems as if the market is vulnerable," at least over "the next three to six months."

To be sure, not all appears to be bad for stocks. The estimate for U.S. second-quarter GDP growth has been revised up to 3 percent. And Treasury yields have fallen even lower, which not only makes it cheaper for corporations to borrow money, but could mean that stocks continue to see residual demand as compared with bonds.

The S&P 500 is up nearly 10 percent year to date, but is essentially flat from its mid-June highs.



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Trading Nation is a multimedia financial news program that shows investors and traders how to use the news of the day to their advantage. This is where experts from across the financial world – including macro strategists, technical analysts, stock-pickers, and traders who specialize in options, currencies, and fixed income – come together to find the best ways to capitalize on recent developments in the market. Trading Nation: Where headlines become opportunities.

Michael Santoli

Michael Santoli joined CNBC in October 2015 as a Senior Markets Commentator, based at the network's Global Headquarters in Englewood Cliffs, N.J.  Santoli brings his extensive markets expertise to CNBC's Business Day programming, with a regular appearance on CNBC's “Closing Bell (M-F, 3PM-5PM ET).   In addition, he contributes to CNBCand CNBC PRO, writing regular articles and creating original digital videos.

Previously, Santoli was a Senior Columnist at Yahoo Finance, where he wrote analysis and commentary on the stock market, corporate news and the economy. He also appeared on Yahoo Finance video programs, where he offered insights on the most important business stories of the day, and was a regular contributor to CNBC and other networks.

Follow Michael Santoli on Twitter @michaelsantoli

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