Three signs that stocks are about to start sliding again
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Associate Editor
David Stevenson Dec 11, 2009
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It's amazing.
There's no shortage of bad news around. From Dubai to Greece, it's becoming clearer that a whole cocktail of new nasties is brewing up for the future.
Yet share prices haven't freaked out. Far from it. Yesterday, the FTSE 100 racked up another 40 points, and on Wall Street the Dow topped 10,400 again.
So when will stock investors finally twig what's on the cards? Well, several key indicators suggest that we're getting close to a big market downswing…
"All of a sudden, the world doesn't seem that much of a safer place", says David Rosenberg of Glusken Sheff. "No amount of global liquidity can disguise unsound leveraged financial positions indefinitely".
In other words, loads of new money has been printed worldwide, which has helped keep all the balls in the air. But too much has been lent to too many of the wrong people. And the risks are growing that they won't be able to pay it back, particularly as there's very little sustained good news on the economic front.
Yet investors keep shrugging off any concerns. The FTSE 100 index is up 50% from its early-March 2009 lows. America's Dow Jones Industrial Average has risen by 60% over the same period.
A guide to where the market's headed
And investors are becoming ever more optimistic, regardless of any bad news. Since 1962, a weekly poll has been carried out in the US by Investor's Intelligence (II). This currently asks 140 investment newsletter writers for their views on the stock market. Last week the II survey showed that the percentage of pessimistic investment writers had fallen to 16.7%. This was the third-lowest bearish reading in 22 years.
Here's the first interesting bit. This survey has proved to be a very handy historic guide as to where share prices are heading next. The lower the bear count, the more likely the market is to fall. In other words, the market tends to do the opposite of what investors are expecting. After all, as we've pointed out before, if everyone has turned bullish, it means there are no buyers left. So the market has only one way to go – down.
Of course, the converse is true, too – mega-bearishness suggests the sellers have all run out. Both are generally good times to make money. That's because 'contrarian' betting against the herd tends to pay off, as we discussed here a month ago: Everyone wants to be a contrarian – but how do you do it? So you do the inverse to the consensus, and wait for the market to go your way.
So how much money might you make from this information? Jason Goepfert of Sundial Capital Research has researched the ten lowest II readings in the last decade and has studied the stock market's performance after each extreme. He found the market lost an average 0.3% one week later and had dropped by 1.6% one month later.
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Another cause for concern
By itself, that looks like small beer. But the II poll isn't the only survey giving cause for concern. There's a second, a retail money market measure that also looks dangerous.
The Investment Company Institute monitors US private investors' money market holdings - the cash they hold in their brokerage accounts. When small investors are optimistic, they spend their cash on stocks. When they go bearish, they dump their stocks and build up large deposits of cash.
Goepfert has built a sentiment gauge from this data by comparing private investors' money market deposits with the overall market cap of the US S&P 500 index. Whenever money market assets climb above 10% of the S&P's market value, he says you have a great buying opportunity. This ratio hit 15% in November 2008, which we now know wasn't such a bad time to buy shares. But when money market assets drop below 5% of the S&P's market cap, it's a good time to sell.
Private investors now hold just over $1 trillion in money market funds - around 8% of the S&P's market cap. In itself, that's not an extreme percentage. But the speed at which cash levels have plummeted from where they reached in November 2008 is extreme.
There's only been one other time in the last 30 years when retail cash balances dropped as fast. From mid-1982 to mid-1983, cash levels plunged from 15% to 8% in one year. Over the next 12 months, the stock market fell around 15%.
So unsurprisingly, the fact that retail investors are now piling into stocks at the fastest rate seen in decades is making Goepfert very wary.
So that's two reasons to be bearish. And they don't stop there. Another set of economic measures tells a similar tale.
The next market fall may be closer than people think
'Leading indicators', which include the likes of building permits, money supply and changes in a company's stock levels, measure the health of the cyclical part of the economy, which depends on economic growth to prosper.
And the rate of change in two key leading indicators, the Economic Cycle Research Institute and US Conference Board gauges which have soared through most of 2009, is turning down, says Albert Edwards of Société Générale. That would be bad news for cyclical stocks. And that suggests the next market fall "is closer than people might realise".
"Though many commentators want to complicate the investment business, we try to keep our advice as simple as possible", says Edwards. "With the market so bullish, a cyclical failure will come as a crushing blow to sentiment. It is time for caution. It's time to sell".
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