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What Happens If the Stock Market Doesn't Correct Soon?


The current cycle could stretch into year-end, where the markets might stumble as they contemplate another government shutdown.

A permabull is defined as somebody who is always upbeat about the future direction of the stock market and the economy. Recently I have been called a permabull by certain members of the media, which may be true since March of 2009, but certainly not true over the past 14 years. Recall, in September 1999 I wrote about the Dow Theory "sell signal" that had occurred. Then there was the Dow Theory "buy signal" of June 2003. Most important was the Dow Theory "sell signal" that was registered on November 23, 2007. Obviously, I am not a permabull. As my father used to tell me, "If you think the markets are going up, be bullish. If you think they are going down, be bearish. And, if you think the markets are going to go sideways, be boorish."

Even over the past four and a half years there have been occasions where I have suggested raising some cash when I thought a meaningful decline was coming. That strategy worked in 2010, 2011, and 2012, but this year I was adamant that "sell in May and go away" was not going to play. However, I did wrong-footedly target mid-July through mid-August for a meaningful decline to begin, but corrected that "call" when Vladimir Putin pulled our president out of his Syrian crisis. Yet my mantra ever since March 2009 has been, "You can be cautious, but don't get bearish." So in response to the "permabull" label, this morning I am going to discuss some of the bearish divergences that have been developing in US markets recently.

First is the divergence between the Russell 2000 (INDEXRUSSELL:RUT), which serves as a benchmark for small-cap US stocks and which has been noticeably weaker than the S&P 500 (INDEXSP:.INX). Since the RUT has been stronger than the overall stock market all year, its recent weakness could potentially be a downside "tell."

Next is the attendant series of charts showing the divergences between the SPX and a rise in interest rates in the high yield complex, the decline in third and fourth quarter GDP estimates, the collapse of forward earnings estimates for the S&P 500, and most troubling, the collapse in Bloomberg's Economic Conditions Index. Studying that chart, one observes how tight the correlation between Bloomberg's index and the S&P 500 has been over the past four years, until recently. In fact, in decades of monitoring the Bloomberg Economic Conditions Index, I can't recall such a divergence ever occurring. The implication is that business conditions are slowing at a very rapid pace, but the equity markets are ignoring that. Of course it could be as I have suggested in that nobody is going to pay any attention to the economic data until December because of the shutdown and the debt ceiling debate.

The next "bear boo" is the Shiller P/E ratio, which at 24.6 is 47% above its historic mean level of 16.5. The implication is that the S&P 500 is 47% overvalued. For reference one should know that the Shiller P/E ratio's historic low was 4.8, and the historic high was 44.2. The bears argue that valuation is making it very dangerous to invest in US stocks, but they have been saying that for more than four years. Here's how the Shiller P/E ratio is calculated:

1. Use the annual earnings of the S&P 500 companies over the past 10 years.

2. Inflation-adjust those earnings using the CPI into today's dollars.

3. Average the adjusted values for E10.

4. The Shiller P/E equals the ratio of the price of the S&P 500 Index over E10.

My issue with the Shiller P/E ratio is that it assumes what has happened over the last 10 years is going to happen again over the next 10 years, and I just don't believe it. In the crash years of 2001 and 2008, the S&P's bottom up earnings came in at $38.85 and $49.51, respectively. I particularly remember the 2008 earnings report because Wall Street's "best and brightest" strategists appeared in Barron's magazine in December 2007, following the November Dow Theory "sell signal," with their earnings prediction for 2008. Those guestimates centered around $100 accompanied by price targets for the year of roughly 1700. The S&P 500 ended 2008 at 903.25. Using a simple P/E ratio leaves the SPX currently trading around 16.4x earnings and at 14.5x next year's estimate of $121.20. Clearly, not as expensive as the Shiller P/E measurement, and if the SPX trades at 16.4x next year's estimate, it suggests a price target of 1987.

Speaking to the bears' "debt worries," to me it is interesting that the debt ceiling crisis came when the deficit is actually coming down a lot faster than even the CBO thought could happen. That decline is going a long way in improving the future outlook. While the bears expect the economy to contract, I believe the capital expenditure cycle that is about to begin will actually strengthen the GDP figures in 2014. Moreover, with a stronger economy, and continuing low interest rates under Janet Yellen, we should be able to gradually reduce the deficit. Fortunately for the US, there is demand for our bonds and we are the world's currency. So what other questions are circling my desk?

Have I missed the bull market? If this is the secular bull market I think it is, they tend to last somewhere between 10 to 20 years, so no, you have not missed the bull market. What do I do with my fixed income? IMO, the secular bull market in fixed income ended in July of last year. Accordingly you should be very careful with the fixed income portion of your asset allocation. If you have to be in bonds I would move to the short end of the yield curve.

Where should I invest now? Ever since January I have said to decide how much money you want to commit to US stocks. Then break that amount into four tranches and invest the first tranche today. Subsequently, pick a future point in time to commit the second tranche (say two months from now). Continue with that plan until you are invested.

Which US stocks should I invest in? I would stick with the large capitalization names that pay dividends.

Should I buy alternatives instead of fixed income? The only fixed income I own is Putnam's Diversified Income Trust (MUTF:PDINX), which is geared for a higher interest rate environment. And yes, there are some alternatives to fixed income, but they have a higher degree of risk. Some of the ETFs playing to a diversified portfolio of REITs or MLPs make sense to me. And the final question...

Does diversification work/forward looking? I will quote the great investor Sir John Templeton: "The only investor that doesn't need diversification, is the investor that is right 100% of the time."

Call for This Week

Random thoughts: We spend 90% of our time on things that only have a 10% impact, and 10% of our time on things on things that have a 90% impact. While teaching kids to drive, it becomes apparent that the best way to get into an accident is to drive while looking into the rearview mirror. Regrettably, that is what most investors do, trying to catch the last investment trend. I know enough to know what I don't know. The answer to nearly every question starts with, "It depends!" Be careful of statistics because a man can drown in a foot of water.

Current thoughts: The Dow has eclipsed the upper side of its Bollinger Bands (read negatively), and although that has happened three times this year, it is still a very rare event! While my timing models suggest this week still has the potential for some upside energy to test the recent highs, or maybe make a higher high, beginning next week they suggest there is another downside window opening. If we don't see a correction start next week, it means that, like late last summer, the powers that be have again been able to prevent the normal corrective process. If so, it implies this cycle could stretch into year-end, where the markets could finally stumble as they contemplate another government shutdown.
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