Is Time About to Run Out on the Stock Market Rally?

I think everyone can agree the latest stock market rally has been an amazing – nearly unprecedented – run for stocks.

Where it seems no one can agree is whether the rally is over.

Here’s how to tell when it will come to an end and how to keep your investment portfolio safe.

Let’s start at the beginning.

Why Investors Need to See the Light and Slow Down:

The Dow Jones Industrial Average is up 46% since March 9, when the world itself seemed to be coming to an end. In the entire 113-year history of the Dow, only six rebounds have been bigger and faster. But the swiftness and magnitude of this bounce-back aren't reasons to be cheerful; they are reasons to be cautious.

In March, stocks traded as low as 11.7 times their average earnings over the previous 10 years, adjusted for inflation, according to finance professor Robert Shiller of Yale University. That put the market at its lowest valuation since January 1986. Today, however, stocks are selling at 18.4 times Prof. Shiller's measure of earnings. That isn't only up hugely from March but is above the long-term average of 16.3 times earnings.

It is at times like these, when a rising market sweeps our spirits up with it, that investors need to evaluate their emotions and consider whether their beliefs and actions are justified.

Sounds like the outlook for stocks isn’t so good, right?

Well, it doesn’t stop there.

The Wall Street Journal goes onto add:

In August, corporate insiders -- officers and directors of public companies -- sold nearly 31 times as much stock as they bought. From last September through this past March, in the depths of the bear market, that ratio was just 2 to 1, according to TrimTabs Investment Research of Sausalito, Calif. The long-term average is about 7 to 1.

It’s easy to make a bearish case in this market. But most of the bear cases can be easily trumped.

This Will Mark the End of the Rally:

Since the March lows, the Dow has rallied more than 45% in just 170 days. Throughout it all, there have been countless comparisons to the 1929-30 rally. A few months after the 1929 crash, the Dow put in a temporary bottom too. The index went on to rally 46% in 148 days. This has some bears saying the rally is living on borrowed time.

True - the rally has been strong and it is showing signs of slowing down, but it’s hardly unprecedented. The greatest stock market rally in history makes the current run-up look quite tame. In 1932 the Dow soared 111% in just 98 days.

That’s what is keeping the bearish sentiment so high. September is only a few days away. September, on average, is the worst month for stocks over the past 50 years.

Of course, monthly averages are hardly good at predicting the future. If they were, we’d all simply short the market in September and buy in December and January (two of the best-performing months) and retire.

The likely real reason for the average returns being so low is coincidence. Dragging September down has been the 1987 crash, Russian debt default in 1998, September 11 terrorist attacks, and last year’s meltdown.

Here’s what I’m getting ready for the end of the rally – whether it’s already over or it will be over in six months, a year, or last much longer.

As for the market as a whole, it reminds me of the late 90s stock market bubble.

If you recall, the Russia debt default blew up the infamously overleveraged hedge fund, Long Term Capital Management. The scare sent the markets tumbling. In response, the Fed chairman opened up the money spigots to limit the damage of a single hedge fund so closely interwoven into the financial markets it caused systemic risk. Sound familiar?

What followed, with the help of a great story in the form of Y2K, was the dot-com bubble. That bubble bled over into biotech stocks and, to a lesser extent, into large-cap stocks.

Everyone kind of knew it was overvalued, but everyone went along for the ride anyways. And for those who had discipline and who were armed with tools like trailing stop-losses, walked away with most of their gains in hand.

The stock market rally is something we have covered at length throughout all of Q1 Publishing’s investment newsletters. And it’s something we are going to continue to watch in the Prosperity Dispatch, our free investment newsletter.