Five reasons stock prices are set to drop
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Associate Editor
David Stevenson Aug 14, 2009
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Share prices in London and Wall Street head higher almost daily. Whatever the news, investors put an upbeat spin on it. So the stock market rally since March's lows has taken on a life of its own.
That's fine while it lasts. But as we've seen over the last two years markets can turn very fast.
Here are five reasons why I think shares are about to drop...
There are too many bulls
In the US there's a weekly poll of stock newsletter writers called the Investors Intelligence survey. This has a great track record as a gauge of investor sentiment. The latest reading shows the lowest level of gloom since the market peaked in October 2007, coupled with the highest level of optimism since January 2008 – just before markets plunged. What's more, says the FT, another survey of individual investors' optimism is near its highest point in over a year.
These are classic signals to contrarians like us that prices are about to crack. As David Rosenberg of Glusken Sheff puts it: "it's highly unlikely that 90% of the economic community can be right on the same thing at the same time".
Investors are acting like lemmings
The FT also points out that American long-term mutual funds - which are similar to UK unit trusts - have just seen a net cash inflow for the 20th successive week.
So playing the stock market is becoming a one-way bet. US 'short interest' – a measure of how many investors expect falling prices - in S&P 500 shares recently fell to its lowest level since February, says Bloomberg. That points to a surge in optimism. And another measure, the Chicago Board Options Exchange equity put/call ratio - which gauges speculative interest and climbs as shares fall - is near multi-month lows.
These are yet more signs that most investors are gambling on the market rising. And that creates the contrarian's second sign of a market top.
Trading volumes are thin
"In a normal breakout you get rising volume", says Tony Cherniawski at Practical Investors. He reckons recent share price rises have actually been driven by many investors literally being caught short – having sold stock they don't own as a bet on prices falling, they've had to close out their bets by rushing back into the market to buy the same shares back. This stampede has forced shares higher.
But that effect won't last. When it ends, prices will drop back.
Company profits are still weak
In recent results releases companies have focused on "underlying" profits – which often strip out inconvenient one-off losses. But this masks the true earnings picture. The reality is that US second-quarter profits were 20% lower than a year ago, says Bob Janjuah at RBS.
Worse, "stock analysts continue to promote corporate earnings lies", says Bloomberg's David Pauly, "their earnings estimates often ignore huge expenditures that can't help but affect a company's health". It means that many shares are nothing like as cheap as they first appear.
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And even where profits have been better than expected, that's been due to aggressive cost cutting – laying-off large chunks of the workforce is common - not genuine growth. Meanwhile sales – the crucial "top" line - at S&P companies are down more than 10%. So the next round of earnings will serve up some nasty shocks.
Dividends are under attack
We're about to face another wave of dividend downgrades on this side of the Atlantic.
Payouts made by 700 of the top London-quoted companies dipped 9% in 2009's first half, says Capita. Meanwhile, listed companies have raised almost twice as much by selling new shares as they've paid in dividends. And this year's second half will be worse. Capita sees an even bigger payout purge which will up the full-year drop to 13%.
This is a double worry - dividend payments are a key sign of firms' future confidence. Lower payouts also hint at smaller-than-expected future profits. And that's bad news for share prices.
When will stocks fall?
The rally could continue for a while yet. But my evidence all points to stock markets falling over coming weeks – maybe sharply. Janjuah certainly agrees. As "Britain's Uber-bear", says the Telegraph's Ambrose Evans-Pritchard, "he was one of the few analysts to speak out early about the dangerous excesses of the credit bubble". He then warned last summer that "a very nasty period is soon to be upon us" just before Lehman Brothers and AIG imploded.
Janjuah reckons the current rally will continue through most of August. But markets will then reach a September 'tipping zone'. That's when key gauges such as business equipment spending, profits, incomes and jobs show there won't be the 'V' shaped recovery – and hence immediate economic rebound – "that's now fully priced into markets".
He sees global stock markets falling back to their March lows, if not lower, with the S&P 500 index plunging to the mid-500s. If the FTSE 100, currently 4,750, moves in line, it would slump towards 2,500.
As he puts it: "the last two Augusts proved pivotal turning points: August 2007 was when everyone wanted to believe policy makers had seen off the credit disaster at the pass. August 2008 was the calm before the utter collapse" in the autumn - "3rd time lucky, anyone?"
In the magazine this week our latest RoundTable - Twelve stocks that will weather the storm - features expert tips on the best bear-proof stocks - if you're not already a subscriber, claim your first three issues free here.
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