Everything’s Hunky-Dory

The one day mini correction on high volume last Friday has passed. Just like Dubai, Greece, and the great recession before it, the alleged Goldman Sachs scandal seems to have already passed. The market continues its onward and upward trajectory with a V- shaped recovery off the bottom from last March 2009. Everything’s hunky- dory, right?

If you examine the VIX Index, also known as the Fear Index, it seems that complacency is everywhere. The VIX has been plunging as the year old rally has continued non-stop. It now stands at an incredibly low level of investor fear, or conversely a high level of investor optimism, given the overall state of the economy. We are currently at levels that have only been seen at market peaks. When the majority of investors feel that there is nothing to fear – that is precisely when fear should be the greatest.

Another method of measuring investor sentiment is the bull / bear ratios. The American Association of Individual Investors, showed bullishness at 48.5%. Usually it is strong contrary indicator when bullishness reaches 50% to 55%. So we are in the warning zone. The Consensus survey measures sentiment of brokerage firm analysts and independent advisors. Its readings are now 75% bullish. The last time it reached these levels was at the market peak back in October, 2007.

A further fundamental way to value the stock market is by evaluating the current dividend yield for the S&P 500. The market’s recent yield was 1.9%. The last time the dividend yield was this low was in December 2007, at the start of the great recession. Historically the dividend yield for the S&P 500 averages 3%. Since dividend yield accounts for as much as one third to one half of the stock markets total return over the long term, a higher dividend yield usually means healthy market returns going forward. The current paltry dividend yield does not bode well for superior returns going forward.

Yet the market continues higher. The rare down days are usually accompanied by higher volume. Nevertheless the multiple up days on low volume continues. The S&P 500 has been up eight of the last nine days. The NASDAQ has been up nine of the past 10 weeks.

Earnings thus far have been very good, but the current stock prices of most of the companies that have reported earnings are up even more than the earnings or revenue growth reported. It may turn out that stocks have already accounted for the better than expected earnings growth. At some point the markets will be forward looking again.

The future has two potential outcomes from my vantage point. One, is the economy is going to have a strong recovery – that is what the stock market is telling us with its V- shaped bounce off the bottom. If this happens, the excess government stimulus, to the tune of trillions of dollars globally, will have to be quickly removed to protect against inflation. Look at commodity prices over the last year – namely look at the price of gas at the pump and anyone can readily understand what I am saying. This will cause interest rates to rise very quickly. That will be good for savers and seniors but bad for everyone else. Interest rate represents the cost of money. As the cost of money goes up, earnings and growth go down.

The second potential outcome is that the economy is not nearly as strong as the stock market has been flashing. That is what leaders such as Ben Bernanke and the Fed have been saying. If this is the case, the outcome will result in a correction for the markets. How far and how fast remain to be seen. It really depends on how weak the economy remains. Job growth and housing appreciation are still nonexistent.

The other question for my two potential outcomes is when? When would a correction start? That answer is also elusive. There are many technical indicators to go along with the fundamental analysis stated above that demonstrate an overbought condition for the markets. The zero interest rate policy that is currently in place is fueling the markets and it could last a while longer. However the sooner the correction happens, the less detrimental it will be to buy and hold portfolios.

What should an investor do today? Be very cautious. These long term winning streaks for the stock market are very rare and usually there is an adjustment that follows. Use stop losses as a floor beneath today’s prices to protect your capital. These stop losses could be placed directly on the exchanges or mental notes of prices which must be executed when breached.