By Anthony Mirhaydari
Dow 16,000. There's nothing like big round numbers to generate excitement and suspend disbelief.
Hitting this milestone was inevitable, of course, as the Dow Jones Industrial Average has spent the last seven months knocking its head on resistance just under this level. It was back then that the Federal Reserve first warned that it could start tapering its ongoing $85 billion-a-month bond-purchase stimulus.
The stock market cooled its heels as the bond market freaked out, which in turn caused the Fed to go into a holding pattern. They are aware of just how fragile this market is — a market that is one of the few bright spots of this post-crisis economy (jobs, income, labor participation, national debt, and other real-world measures remain disappointing).
So the cheap money kept flowing, more than $500 billion over this time. It has lulled investors into a sense of complacent overconfidence that sets the stage for a correction taking us back under the 16,000 level, at least temporarily.
Why?
Consider that with corporate revenue growth stalling and the "cut costs to boost earnings" strategy played out, stock-buyback announcements during the thrid-quarter earnings season dropped to a four-year low — levels not seen since October 2009. At the same time, IPOs and secondary share issuances are on the rise.
Long story short: CEOs are voting with their actions that the bond market is cheap, stocks are overpriced, and that the economy may be more vulnerable than the bulls would like to admit.
None of this mattered. The S&P 500 is up nearly 9% with no major drawdowns (less than 1%) since third-quarter-earnings season started. Since 1950, the average earnings season has returned 1.3%. But it eventually will since the use of cheap debt to leverage up corporate balance sheets and bolster the stock market is fading.
Also contributing to the rise has been the postponement of the debt-ceiling fight in Washington. Democrats and Republicans for years have been kicking the can down the road when it comes to tough issues like reforming entitlement programs, streamlining the tax code, and actually passing a budget for the fiscal year. The market is ignoring the fact this fight will return starting in December.
"Dumb money" sentiment is also off the charts, while the "smart money" investors keep pulling back. Consider that the percentage of assets in Rydex funds that are in money market accounts has dropped below the lows seen as the last bull market was peaking in 2007. Or that NYSE margin balances have surged to levels not seen since the dot-com bubble was peaking in 2000. That's unsustainable.
Technicals are also vulnerable, as stock prices get too extended on narrowing market breadth as fewer and fewer stocks participate in the rally. According to SentimenTrader, Friday was only the third time since 1997 that the S&P 500 rose to a new 52-week high with at least a 0.4% gain but with less than two-thirds of stocks rising on the day for three days in a row. The other dates were Oct. 6, 1997, March 23, 2000, and Nov. 22, 2005, all preceding short-term corrections.
So far, Monday isn't looking much better: As I write this, there are just 369 net advancing issues on the NYSE, down 61% from Friday.
Historically, this pattern marked market peaks in 1950, 1955, 1959, 1968, 1975 and 1980, with an overall return over the next three weeks that averaged -1.0%, with 41% of days showing a positive return.
Moreover, the S&P 500 has now climbed for six consecutive weeks to at least a 10-year high. Of the other 20 weeks in which this has happened since 1928, the streak extended to seven weeks half the time. Over the next month, the maximum loss of -2.4% averaged three times as much as the maximum gain of +0.8%.
I'm not saying the economy won't continue to improve. I'm not saying that inflation won't stay down and keep the Fed pumping. And I'm not saying that other central banks, from here to Japan and Europe, won't keep the stimulus flowing. Although I have my doubts.
I'm just saying that things have gone too far, warnings signs are flashing red, and now's the time to fight the urge to chase a market rise that seems to be in the midst of a flashy finale fueled by a singular catalyst: The fact that money is cheap.
