The U.S. stock markets have been on a roll lately breaking all-time highs on numerous occasions over the last several months.  The months of September and October of any year have often been volatile with steep pullbacks.  Indeed, some of the most severe stock market crashes in history have occurred in October (1929, 1987).  But this year nothing could be more the opposite.  The markets have all steadily climbed to record highs, and trading activity has maintained a steady, complacent pace throughout this tricky time of year.  But does that mean that a major pullback is imminent and we should begin to sell?

 

A look at the technicals:

The short term Stochastics Oscillator has shown bullish trading tendencies since the end of August.  Only this last week or so has it begun to weaken.  Although market momentum is currently neutral the rally is not broad based but is instead confined to a limited number of popular stocks whose volume is powering the indices higher.  The broader market is showing weaknesses in many sectors.  The volatility index (VIX) has been in a bearish mode (<11) since early summer.  The contrarian indicators of the percentage of bullish or bearish advisors has a difference of 47.2 making it the most bearish it’s been since 1987.  The strength indices are all trending down which means that stocks are gravitating towards being under distribution (selling) rather than accumulation (buying).

 

The end of easy money:

Since the financial crisis of 2008 interest rates have been ultra low.  The Federal Reserve has poured several trillion dollars into the money supply by way of buying U.S. Government bonds in a program known as quantitative easing.  Major amounts of this money injected into the economy have found their way into the stock and bond markets driving yields down and prices up…way up.  The Fed ended quantitative easing in recent years, and now has indicated that it will reverse the process by selling those same bonds into the open market taking those trillions of dollars back out.  Further, we’ve seen that Fed Funds rates (the rates that banks pay to borrow from the Fed) have been slowly but steadily climbing up.

 

The baby boomer effect:

The U.S. population is shifting dramatically towards older age with the soaring number of baby boomers reaching retirement.  As this generation leaves the work force the amount of savings they have achieved will need to be consumed, and this could drive huge sums away from the investment sector of the economy into the consumption sector.  Mutual Fund withdrawals in excess of deposits translates sooner or later into stocks and bonds being sold.  This condition will only increase over the next decade or so until the baby boomer effect wears off and this population shift is absorbed.

 

Overvalued markets:

The composite price/earnings ratio for U.S. markets since the 1920’s has been about 16 to 1, meaning that even valued stocks would have a price of about 16 times their earnings per share.  Currently this ratio has been running in the low to mid-twenties depending on sector.  For technology the number is 28 to 1.  The search for yield has driven bond prices so high that yields for corporate bonds with AAA to BBB+ credit have plummeted to as low as 2-3%.  As the price of bonds rises the yield falls in an inverse manner.  Stocks that are undervalued (i.e. a price to earnings ratio of below 16) are often unwanted by many investors which drives those prices down. The reason could be that some of those stocks are in financial straits.

 

Reversion to the mean:

Statistically the mean is the average of a group of data.  The broad markets over time have shown tendencies to revert back to the mean whenever long rallies or deep crashes take place.  Many investors will say that this is probably the only theorem that can be relied upon over the long run.  If it were to apply today, the markets would be in for a serious or prolonged pullback.

 

To sell or not to sell:

Some analysts have proven via studies that the average investor should remain in the markets overall as much as possible to take advantage of the days that stock prices rise, and limp through the days that they fall.  This is an important consideration as the markets often rise slowly and steadily but fall sharply and quickly.  Timing the market is a very difficult exercise even for experts.  Rebalancing more often than once per year is one endeavor that the private investor can easily do to insure that his/her portfolio can enjoy moderate increases during the upswings and withstand moderate to severe pullbacks during downswings.  Another method is to acquire short positions which will cushion the downturns and still enable the investor to hold long positions.  If the market should sharply crash, the best advice is to sell early into the crash or wait it out.  All too many investors will sell well into the crash thereby losing larger portions of capital and giving up too early on the recovery.
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