As the markets reach new highs, investors have begun to express
caution instead of celebration.
Since Nov. 15, 2012, the S&P 500 has risen an impressive 15%.
That works out to be a 45% annualizedgain . And the whole time, a
significant number of investors have remained dubious, citing ample
reasons why themarket should be moving lower -- not higher. And as
the market has climbed this "wall of worry ," even the most
ardently pessimistic bears have thrown up their hands in
My colleague Adam Fischbaum touched on some concerns
in this column
To be sure, the fourth-quarterearnings season held few negative
surprises, and first-quarter results are likely to be at least in
line with forecasts. Plus, the increasingly robust employment
picture indicates the U.S.economy almost surelywill avoid
arecession in 2013, even with the boulders that Washington policy
makers throw in its path.
Still, a host of otherfactors leaves the bears unconvinced this
rally has staying power. Watch these factors closely and be
prepared to take profits before any modest pullback morphs into a
Here are the unusual factors driving the current market.
According to Bloomberg News, only 5.6% of allshares are now held in
short accounts, down from 12% five years ago. That's a 53% drop,
which is the lowest level in history. In fact, much of the drop has
come in just the past four months.
Short sellers often move as a herd. When they realize their
colleagues' resolve is weakening, as evidenced bybacking away from
short positions, they also capitulate and cover their positions.
After all, it's unwise to stand pat and watch heavily shortedstocks
rally. And when short sellers seek to cover their positions, they
must buy back shares they borrowed, which creates a form of buying
pressure for the market.
In a study conducted by the BespokeInvestment Group, the
following stocks had a short position equivalent to at least 25% of
theirshares outstanding as the year began, but short covering has
pushed them up sharply.
Short Interest as a % ofFloat (SIPF)
At some point, perhaps soon, this phase of short covering may
come to an end, removing one of the sources of fuel for this rally.
And paradoxically, it's often wise to seek out short ideas once
short-selling is exhausted. That's because ashort squeeze -- such
as in the stocks noted above -- can lead to renewed selling
pressure once the shorts are emboldened to try their hand
Few investors recall it now, but margin debt was one of the biggest
factors behind the huge rise and fall of dot-com stocks. Fevered
investors borrowed from theirbrokers in a rush to buy stocks in
1999 and 2000. Yet by the spring of 2000, those same brokers were
calling their clients asking for theirmoney back, as a falling
market shrank theequity balances to levels that made the margin
loans look too big. As investors sold off their falling dot-com
stocks, the market moved lower, triggering even more margin calls
and creating one of the ugliest years ininvesting history.
Investors are at it again, taking on debt just to buy rising
stocks. They are pouringcash into their accounts in order to chase
this rally higher, as they did in 1998 and 1999. Back in
August,gross margin debt (prior to the reflection of offsetting
cash) stood at $288.6 billion.
Here's what has happened since.
Surging Market Debt ($billions)
This $80 billion spike in gross margin debt in just six months
won't be a problem if the market holds its ground in coming weeks
and months. And indeed, many investors have built in a cash cushion
to guard against market pullbacks. But it's those investors who are
using margin in an especially aggressive fashion that createmarket
risk . Major market pullbacks would force them into selling, which
creates further market weakness. As I
in October, "Even if just 20% or 30% of margin accounts get amargin
call from brokers, then we're talking about tens of billions in
selling pressure into an already weak market. This can push the
market down to trigger the nextwave of margin calls."
A tiredbull ?
Abull market is a gain of at least 20% without a 20% pullback in
its midst, and there have been two since the dot-com meltdown in
2000. The first one began in October 2002, lasted 67 months and
generated a 101% rally in the S&P 500. The next -- and current
-- bull market began in March 2009, and has delivered a 128% gain
after only 48 months. There have been only two bull markets since
1956 that have delivered greatergains than the current bull.
In a study conducted by Merrill Lynch, the average bull market has
lasted 30.7 months and delivered a 104% gain. Sure, this bull can
continue running, but historically speaking, we're living on
Profits are not as impressive as you might think
Analysts repeatedly have slashed their near-termprofit forecasts,
only to find companies exceeding the newly lowered set of
expectations. That has given the impression of better-than-expected
profits, but you'll see something different if you take a wider
At the start of 2012, all of the companies in the S&P 500
were expected to earn roughly $118 a share in 2013. Yet with each
passing quarter, analysts have been taking an ever-dimmer view.
Now, the aggregated profit forecast for the S&P 500 in 2013 is
just $108 a share. If Washington's ongoing circus continues to vex
the U.S. economy, we might be looking at S&P 500earnings per
) of just $100 this year. That's the view of Morgan Stanley
strategists -- one that may soon be shared by others.
Action to Take -->
With the always-present possibility of a market reversal, keep a
close eye on the daily closes of the S&P 500, as they can
provide insight. A few days of market drops may seem innocuous, but
can signal a new trend.
For example, from Oct. 5, 1987, until Oct. 16, 1987, the S&P
500 lost roughly 1% in every session. That last date marked the
fourth straight days of losses, and investors had seen enough. In
the following session on Oct. 19, 1987, the S&P 500 fell 20% in
just one day. So don't take signs of profit-taking too lightly.
Still, the major indexes are nicely above their 50-, 100- and
200-day moving averages. Yet many technical analysts keep an eye on
the50-day moving average chart as a sign that the bull is getting
tired, and abear may be on the prowl. For the S&P 500, the
50-day moving average stands at 1,495, roughly 55 points, or 3%
below current levels. If you're nervous about when to take profits,
keep an eye on that number.
A much simpler way to avoid getting crushed by a market rout is
through the use of stop-loss limit orders. As traders like to say
in a raging bull market, "keep your stops tight."
Let's use an example. If you invested in
Netflix (Nasdaq: NFLX)
last fall, you've seen its shares soar by about 200% to $180 a
share. Can Netflix move even higher? Perhaps. Can Netflix be hit by
massive profit-taking? Surely.
That makes this a good time to place a stop-losslimit order for
Netflix at about $170. If shares start to weaken, the crowd could
trigger even bigger selling (just as we've seen with Apple during
the past fewquarters ). Remember, it's not what you think astock is
worth, but what the crowd thinks it's worth. And if the crowd
starts to change its mind, you can't afford to stick around.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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