Sweet Stock Market Lullaby - Followed by Rude Awakening?
Posted 12/20/2010 1:14 PM by Simon Maierhofer
Sweet Stock Market Lullaby - Followed by Rude Awakening? - NASDAQ.com
SAN DIEGO (ETFguide.com) Rock-a-bye baby, in the treetop ... are you asleep yet?
The stock market is lulling investors to sleep. Since early September stocks have gone nowhere but up. Four weeks of steady gains have rekindled optimism and created a state of euphoria not seen in years ... since late 2007 to be exact.
The irony of this article is that few investors will feel compelled to read anything that resembles a warning or contains a bearish message. The few that read this piece will probably scoff at it. That's how bear market rallies work and that's why they are effective.
The soothing rhythm of the VIX (Chicago Options: ^VIX) has lulled investors into a state of complacency. If you had to describe investor's alertness in sleep lingo, a state of REM sleep would probably be the closest comparison.
History tells us that the (bear) market only strikes when least expected.
Based on a variety of sentiment measures, a stock market (NYSEArca: TMW) decline is viewed to be less likely to happen now than in 2000 or 2007.
No Hedging Required - 2011 Will Be Gangbusters
Investors and traders are content to hold on to massive long positions without hedge. One of the easiest ways to hedge your stock portfolio is via put options. The CBOE Equity Put/Call Ratio has tumbled to the second lowest reading in years. The only time investors hedged less was in April 2010.
Back then, the put/call ratio dropped to 0.45. The lack of hedging is dangerous for prices because the market is without a safety net. The only option for spooked investors without hedge is to sell. Selling causes prices to drop.
On April 16, 2010, the ETF Profit Strategy Newsletter warned of the consequences of a low put/call ratio: 'Selling results in more selling. This negative feedback loop usually results in rapidly falling prices. The pieces are in place for a major decline. We are simply waiting for the proverbial first domino to fall over and set off a chain reaction.'
The first domino dropped just a few days later, setting off the May 6 'Flash Crash' and ultimately resulted in a swift 15% correction for the Dow (DJI: ^DJI), 17% correction for the S&P (SNP: ^GSPC), 19% for the Nasdaq (Nasdaq: ^IXIC), and 21% for the Russell 2000 (Chicago Options: ^RUT).
This Time is Different
The spirit of 'this time is different' is one of the most fascinating phenomenons known to Wall Street. Investors' sentiment precisely follows the ebb and flow of stock prices. When prices are up, the future is expected to be bright. When prices are down, the future is supposedly bleak (just think of the 2007 peak and 2009 bottom).
This approach of linear extrapolations feeds the herding mentality, which contrarians use as contrarian indicators. This approach is not foolproof but, nevertheless, is one of the most accurate, if not the most accurate timing tool known to underground Wall Street aficionados.
The chart below illustrates the four most prominent occurrences of extreme optimism, or the 'this time is different' effect. The green line connects the price of the S&P with the timeline and various sentiment gauges.
Investors thought this time is different at the 2007 peak, in May 2008, in January 2010, and again in April 2010. The only thing different at all four times was the velocity of the descent, but each period of euphoria was greeted by despair.
Optimism and Bad News
If you have watched CNBC's 60 Minutes over the past two weeks, you are aware of some serious 'Black Swans.'
Scott Pelley's introduction to Ben Bernanke's interview couldn't have been more sobering: 'That is the worst recovery we've ever seen. Ben Bernanke is concerned. Chairmen of the Fed rarely do interviews, but this week Bernanke feels he has to speak out because he believes his critics may not understand how much trouble the economy is in.'
The financial media, however, ignored Ben Bernanke's outright scary assessment of the economy and focused on the silver lining: A bad economy may lead to QE3 and its cousins QE4 and QE5. What's better, an improving economy or more QE? Apparently QE is just as good as more jobs.
Yesterday's 60 Minutes focused the next big thing; Municipal and state defaults. In the two years since the 'Great Recession ,' states have collectively spent nearly half a trillion dollars more than they collected. There's a trillion dollar hole in their public pension fund and according to New Jersey's Governor, the day of reckoning is near.
Meredith Whitney, one of the few analysts who foresaw the bubble building in banks (NYSEArca: KBE) and financials (NYSEArca: XLF) believes at least part of the three trillion municipal bond market will unravel within the next year.
For much of 2010 municipal bonds were brewing their own little bubble. As it is common with bubbles, they are rarely foreseen by the public eye. In the case of muni bonds, yield hungry investors ignored the red flags.
On August 26, the ETF Profit Strategy Newsletter warned that it is time to get out of muni bonds (NYSEArca: MUB), corporate bonds (NYSEArca: LQD) and Treasuries (NYSEArca: TLT). The chart below shows what has happened to muni bonds.
History Rhymes
Yes, history doesn't repeat itself but it often rhymes. In 2007, Merrill Lynch's Global Economics Report foresaw a bright future: 'The Merrill Lynch global economics team believes that the economy will continue to grow in 2007 - with no sign of a significant cyclical slowdown.'
According to J.P. Morgan, Barclays Capital and Goldman Sachs (Merrill Lynch failed to foresee its own demise in 2007 and is no more), the S&P will gain between 15 - 20% in 2011 and the 'economy will continue to grow in 2011.' No, this time is different, really!
According to history, now is the time to at least be cautious and protect your investments. An ounce of protection is worth more than a pound of cure. Based on long-term valuation metrics the stock market is priced to deliver pain, not gain (see November 2011 ETF Profit Strategy Newsletter for a detailed analysis).
Based on sentiment, the market is overheated and due for a correction at the very least. Timing a top is tricky, but based and support and resistance levels and seasonal patterns it is possible to narrow down when the market is ready to roll over.
The ETF Profit Strategy Newsletter includes a semi-weekly update along with the most recent technical analysis and important support/resistance levels. A break below major support is likely to break the bulls' spirit and the market's streak ... while most are still sleeping.
Oh, here are the missing lyrics for Rock-a-Bye Baby: 'When the wind blows, the cradle will rock. When the bough breaks, the cradle will fall. And down will come baby, cradle and all.' It doesn't sound like a good night's sleep.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.
Sweet Stock Market Lullaby - Followed by Rude Awakening?
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