The S&P 500index rose another 3% last week, continuing a
winning stretch that began last fall.
Since Nov. 7, the S&P has risen 22%. That works out to be
a roughly 35% annualizedgain . Trouble is, therally is
increasingly due to a perception by individual investors
thatstocks can only move in one direction: up.
In its most recent survey, the American Association of
Individual Investors (AAII) noted that the percentage of
investors who are currentlybearish is now less than 20%. That's
the lowest reading in 18 months, yet as legendaryfund manager Sir
John Templeton once noted, "The time of maximum pessimism is the
best time to buy, and the time of maximum optimism is the best
time to sell."
I've already researched one half of that maxim. Back in 2010,
I noted that stocks tend to rally when that AAII survey finds
fewbullish investors. The logic is quite simple: When investors
are in a negative mood, they have already pushed stocks down to
levels that are too low to ignore. As Templetonnotes , maximum
optimism should be of equal concern.
Discussing the sharpgains posted in themarket last week, MKM
Securities' Katie Stockton noted that "short-term momentum was
strong enough to lift the S&P 500 above its June levels,
while generating abundant breakouts on the individualstock level.
Breakouts tend to foster additional momentum," which she adds can
lead to overbought conditions.
In effect, technical indicators like momentum -- not
fundamental indicators like valuations and growth rates -- are
ruling this market.
It's important to think aboutissues such as momentum and investor
bullishness as we head intoearnings season , whichwill
replacespeculation with fact. Companies in the S&P 500 are
expected to boost profits 3% from the same quarter lastyear ,
though the actual figure is likely to end up closer to 4% or 5%
once the numbers have been digested. In each of the past three
earnings seasons, year-over-year profit growth has been 1 or 2
percentage points above early season forecasts.
Yet the real risk to stocks will be based on what companies
have to say for the rest of 2013. Both a strong dollar (which
mutes foreignearnings ) and a fresh slowdown in key emerging
market economies could easily compel companies to set a lower bar
for the next twoquarters .
There's an unusual stock market correlation that has developed
over the past 15 years that investors should heed. In 2000 and
2007, the amount ofmoney that investors had borrowed to buy
stocks (that is,margin debt ) surpassed $350 billion. In both
cases, the stock market was sharply lower a year later, partially
induced by forced margin selling -- and more importantly, the
U.S.economy had slipped intorecession by then. It's as if
investors became overly aggressive with margin debt right at a
time when they should have been tilting toward caution.
Well, for the third time in 15 years, margin debt has again
moved above $350 billion. The figure has stayed constantly above
that threshold for the whole year. (Data are only available
through May, which saw a modestdowntick , likely induced by
"tapering" comments by the Federal Reserve on May 21, though the
trend may have been reversed as those tapering comments have
subsequently been walked back. The next data will be released in
The Move ToCash
Thanks to aggressive recent stock buying, many investors have
come close to exhausting their sidelined cash and are "all in,"
as they say in poker. But having all of your chips on the table
can be dangerous, especially if you carry margin debt as
So while your gut may tell you to stay focused on further
market gains, your head should be talking you into locking in
profits. Yet which stocks should you sell during this earnings
In market environments with less froth, you should always seek
to cull the bad stocks from your portfolio and "let your winners
ride." But the current environment, which has seen more than 90%
of the stocks in the S&P 500 move above their200-day moving
average , means that even great stocks should be in question.
My rule of thumb: Unless a company can make a solid case for
robust profit growth over the next few years, the time may be
here to take profits.
I would also prioritize my portfolio, separating the
low-priced stocks (interms of price-to-earnings, price-to-book,
or price-to-cash flow) from the high-priced ones. Though both
types of stocks would flourish if the market moves yet higher,
the lower-priced stocks at least have betterdownside protection
if the market moves lower. Lower-priced stocks are also more
likely to initiate share buyback ordividend hikes if the market
comes under deeper pressure.
Risks to Consider:
With U.S. trading partners in distress, this coming earnings
season could take a much more somber tone. This is no time to be
complacent (even though theVIX index -- the "fear gauge" -- is
again below 14, signaling historically high levels of
Action to Take -->
Instead of focusing on the market, keep a close watch on the
stocks in your portfolio. Examine the coming quarterly results
(and outlooks). Merely "decent" business conditions are no longer
grounds to hold any stock that has appreciated sharply in recent
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