Dec 16, 2010

Stock Market Bulls Warned: Get Ready for a Sharp Drop in Stocks

By Andrew Mickey, Q1 Publishing

The Bernanke Bubble is showing its first weakness in months.

Yeah, I know. Stocks have continued to inch higher almost daily. The volatility of late spring is a distant memory. The only uncertainty for most investors is seemingly how great next year will be.

Two indicators, however, have recently flashed some major warning signs. The last time they did stocks fell 48% and 20% across the board.

That’s why now the prudent move is to take precautionary action, build up some cash, and prepare for a sharp and unexpected (for most investors) dip.

Is Everyone In?

Investors naturally become more bullish as the markets rise. The last few months have been no different.

This week Investors Intelligence reported the proportion of investment newsletters and advisors it surveys are bullish has surged in recent months. The survey found 56.8% of the advisors it follows are bullish. Only 20.5% are bearish.

Despite the “good news” of rising bullishness, the survey reveals the rally could be due for a sharp correction.

You see, the 56.8% bullish is highest level of bullishness in almost two and a half years. The last time the survey found bullishness so strong was in July 2007. We all know what would follow after that.

Of course, joining the sky-is-always-falling crowd based on one survey is an extreme move. That’s why it’s important to note the survey isn’t the only recent warning sign.

“Fear” Hits a Two-Year Low

The other warning comes from the CBOE S&P 500 Volatility Index – a.k.a. “the VIX” or the “Fear Index.”

The VIX tracks the premium on S&P 500 option contracts. It is a direct reading of the cost of “insurance” against a market drop. The lower it is, the lower the fear, and the less it costs to insure against a market drop.

The chart below shows the VIX has fallen to ominous levels below 17:

The last few times the VIX hit this level, a sharp correction (or worse) followed.

When the VIX hit 17 in September 2007, the S&P 500 was 1280. A year later the S&P 500 was down 48%.

When the VIX fell below 17 in April 2010, the S&P peaked at 1215. Two months later the S&P 500 was down 20%.

Earlier this week the VIX fell below 17 for the first time since the April correction and S&P 500 sits at a precarious 1235 – right in the “sweet spot” for a sharp correction.

Will the results be “different this time?”

Only time will tell, but odds are it certainly won’t be any different.

Let the Pain Begin

We realize trying to predict the short-term market movements is nearly impossible.

As strict adherents to the principles of risk and reward, however, we know the risks are greater now than they have been in months and the potential rewards are smaller than they have been in months.

Most investors, however, do not follow the same principles. As a result, we’re looking at a situation where most investors are selling bonds for the first time in years as rates rise and they’re taking that free cash and piling it into stocks.

All signs point to them falling in a dangerous trap. The markets may tack on a few more percentage points of gains in the short-term. But when they turn, the correction will be fast and hard given the extreme bullishness.

We realize the problem though. With money market funds paying an average of 0.70% per year, it’s tough to sit in cash right now. But given the overall situation, it’d be far better to walk away with a measly 0.06% in interest for the month than a loss of 10% or more when the inevitable correction comes.

Remember, when everyone has bought stocks that wants to buy them, there’s only one way for stocks to go.

It reminds me of the old broker saying: Is everyone in? Let the pain begin.

With confidence at extreme highs and fear at extreme lows, certainly almost everyone is “in.”

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing