4 Things About This Rally That Terrify Me

by James Brumley | January 30, 2013 10:20 am

On the surface, the stock market looks bulletproof right now. The S&P 500 rallied for eight straight days in mid-January (a feat not performed since 2004), and just when it looked like the party might be over after Monday’s modest dip, the bulls stepped up to the plate again Tuesday to carry the index to new multi-year highs.

What’s not to like?

Well, fellow traders, I’ve said it before and I’ll say it again: The time to get most worried about the market is when it seems like there’s nothing to worry about. That’s why I’m terrified now.

See, contrary to popular belief, there are a few things wrong with this rally that could come back to bite us sooner rather than later.

#1: Despite the Rally, Volume is Fading on the Way Up

SP500volume 300x252 4 Things About This Rally That Terrify Me
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Although trading volume has been drifting downward for years, it has continued to dwindle even over the past four weeks as stocks have continued to move higher. Though that condition can persist for a while, it’s not a prescription for longevity.

If this rally is to last, it eventually will need more and more buyers. Not fewer and fewer.

Earnings Have Technically Been ‘Good,’ But …

As of the end of last week, 148 of the 500 companies that make up the S&P 500 have reported last quarter’s earnings. Of them, 98 (66%) topped estimates, 30 (20%) missed estimates and 20 (14%) simply met estimates. That’s a little subpar.

More important, the S&P 500 is now on pace to earn $23.84 for Q4 of 2012. That’s only 0.4% higher than the year-ago figure, and well shy of the forecast profit of $26.87 that the pros were batting around just a couple of quarters ago. That sure beats Q3’s 5.1% dip in earnings, but aside from that quarter, it’s the weakest year-over-year growth the market has seen since 2009.

Sure, analysts are expecting to see earnings grow by 15% in 2013. Just bear in mind these are the same analysts that were at one point looking for a growth rate of more than 19% for last quarter. We’re nowhere even close to that.

Point being, earnings need to improve — dramatically — to keep this rally going.

Key Bellwethers Are Frighteningly Overextended

To give credit where it’s due, Google (NASDAQ:GOOG[1]) was one of the companies that posted meaningfully solid results last quarter. But its stock is up 33% since last June, with a big piece of that move unfurling just since mid-November. Strong results or not, that’s just a lot of temptation for the would-be profit-takers.

It’s not just Google that looks and feels overbought, though. Gilead Sciences (NASDAQ:GILD[2]) is up 64% over the past year. FedEx (NYSE:FDX[3]) has gained 11% in less than a month. Lowe’s (NYSE:LOW[4]) — a building supply company that has inexplicably been unable to participate in the rebound from the construction industry — has gained 35% in just five months, hitting new all-time highs in the process.

Visa (NYSE:V[5]) also has reached new multiyear highs recently after running up 54% gains in the past 52 weeks. Yes, Visa has backed that stock performance up with impressive earnings growth, but like so many other major names, Visa has just moved too far, and too fast, to not expect the weight of those gains to start bearing down.

Psychology

I saved the best reason to be scared for last: the psychological impact of just getting close to the S&P 500’s prior peak (in October 2007) at 1,576.09. We’re about 72 points away from that level right now.

All the trading theories say “buy new highs.” All the fundamental theories say “earnings matter — charts don’t.” I respectfully disagree. If everyone always bought new highs, stocks would never fall back. If earnings mattered, the S&P 500’s P/E ratio wouldn’t have ranged anywhere from 12 to 20 over the past decade.

Reality: Like it or not, and rational or not, investors freak out and make panicked decisions when stocks revisit previous critical levels. It might be the case that most traders are mentally — maybe even subconsciously — ready to hit the sell button right when that peak is revisited. In fact, I’m reminded of the fact that the 2007 peak for the S&P 500 was also within 25 points (within 1.5%) of the March 2000 peak. Coincidence? Maybe.

Or maybe the market just had it in its head that stocks were about as high as they were able to go, which led to a self-fulfilling prophecy.

Bottom Line

I know it’s an unpopular opinion, but I’ve been an investor as well as an impartial observer of the market for more years than I care to admit now, and I’ve seen this kind of thing before.

When things look too good to be true, odds are the rug is about to get pulled out from underneath us — if only a little bit. Never say never.

As of this writing, James Brumley did not hold a position in any of the aforementioned securities.

Endnotes:
  1. GOOG: http://studio-5.financialcontent.com/investplace/quote?Symbol=GOOG
  2. GILD: http://studio-5.financialcontent.com/investplace/quote?Symbol=GILD
  3. FDX: http://studio-5.financialcontent.com/investplace/quote?Symbol=FDX
  4. LOW: http://studio-5.financialcontent.com/investplace/quote?Symbol=LOW
  5. V: http://studio-5.financialcontent.com/investplace/quote?Symbol=V

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