Markets hit tops or bottoms when almost everyone shares the same
opinion. Current conditions in the U.S. stock market are reaching
an excess of bullishness and this indicates a top could be forming.
Investors should proceed with caution.
When it comes to market opinion, the majority is usually right and
investors should generally move with predominant view in the short
term. However, when majority opinion starts to become overwhelming
- say less than 20% of investors are bullish or bearish - then herd
behavior has taken over and it's time to think about stepping
aside. At extremes there is no one left to buy or sell, so there is
no more fuel left to propel the market in the direction that it has
been going. The U.S. stock market has probably already reached that
News media coverage is one of the best gauges of whether or not a
market has overreached. When it starts to become too positive or
negative, the end of the trend is usually near. News coverage for
the recent market rally has indeed become extremely positive. When
the Dow Jones Industrial Average closed above 11,000 yesterday
(April 12th), it got a lot of glowing press reports. This new high
for the rally was hit on volume that was below average - an
indication of a lack of enthusiasm from market participants.
Declining volume has been a serious problem for the rally for a
long time now and will eventually do it in.
The dollar has had a significant sell off from around 82 to 80 in
the last few days because of the Greek bailout. Money has flowed
out of Europe during the crisis and into North America, helping to
drive up the U.S. stock market as well as the dollar. A resolution
to the crisis will reverse this flow and be bearish for U.S.
assets. In reality, the problems in Greece are not over. While a
bond auction held yesterday was quite successful in terms of
selling the bonds, the interest rates Greece paid were very high -
more than double the rates from the January 12th auction for
similar debt. Greece's problem wasn't selling its bonds, but the
high rate of interest it had to pay on those bonds. So far, the
bailout doesn't seem to have fixed the actual problem. While money
may no longer be flowing out of Europe, it may not be quite ready
to return there just yet. When it does, the U.S. stock market will
Yale professor Robert Shiller has just released an updated version
of his historical PE chart for the S&P500. The current level,
just below 22, is around the long-term market peak in 1966 and is
higher than the PE before the 1987 crash. It is well below the 30
level reached in 1929 and the 44 level reached in 2000 though.
Investors should assume that the current 22 number understates the
actual PE ratio. Changes in accounting rules during the Credit
Crisis have made corporate earnings much higher than they would
have been, especially for the financials. The New York State
Comptroller's office reported that Wall Street's earnings were
three times larger in 2009 than they were in 2007, which itself was
an all time record year for earnings. Investors should wonder how
earnings could triple from historical highs during the worse
economic downturn since the Great Depression. Disneyland accounting
along with the federal government transferring money from the U.S.
treasury into the coffers of bailout recipients is the answer.
As always, investors should pay close attention to the VIX, the
S&P volatility index. A low number indicates investors have
become too complacent and the market is likely to start selling
off. The VIX fell to 15.23 yesterday and is testing levels last
seen in May 2008 and October 2007. The 2003 to 2007 bull market
peaked in October 2007 and stocks fell off a cliff in the fall of
2008. Investors were extremely optimistic during the 2007 VIX low,
as they always are during a market top.
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