Daily Gains Letter

Protect Yourself—Dow Jones Industrials Very Vulnerable

By for Daily Gains Letter | Mar 12, 2013

120313_DL_clarkA lot of good news is priced into the stock market right now. Fourth-quarter earnings season is on the horizon, and it will have to be a good one for stocks to keep appreciating.

There still aren’t a lot of reasons to be a buyer in this stock market. Even just looking at a five-year chart of the S&P 500, the market seems pretty stretched and is due for a correction.

Ben Bernanke and Alan Greenspan have been so accommodative to Wall Street and the stock market. But it’s true that it does not pay to fight the Federal Reserve, even if you don’t agree with the central bank’s policy actions. I just don’t see an end to the cycle of money supply growth.

Price inflation already exists in this economy, though I’d say it’s really more like four percent compared to what is reported. Everything is going up in price, so it is absolutely critical that after-tax incomes go up as well—and that’s going to be a continuing problem going forward.

I think we have the makings of a substantial stock market correction that could happen very soon, even if we don’t get any particularly negative data. The market has been ticking higher fairly consistently for four years now, and we’re due for some downside.

First-quarter earnings expectations have flattened right out, and that makes sense; but large corporations are still being highly cautious with their outlooks, and they’ve been very good at beating consensus, typically on either revenues or earnings—though not both in most cases. Some consensus data collectors are now reporting increased earnings expectations for the bottom half of 2013 and going into 2014. Of course, a lot can change between now and then, so it’s important to take it all with a grain of salt.

Stocks in the Dow Jones Industrial Average have been particularly strong lately, and it reflects the strength that many large, old economy companies have been reporting in their earnings results. It also reveals fragility in investor sentiment, with investors sticking to safer, higher dividend paying stocks.

The stock market’s breakout since the beginning of this year, particularly among the Dow Jones Industrials, is very similar to the action at the beginning of 2011 and 2012. In both years, the stock market started strong, and then experienced an extended consolidation, beginning in the spring. A similar scenario is in the cards this year, with corporate revenues (not earnings) now being what buyers are worrying over.

From my perspective, all eventualities are on the table for the stock market this year. We know the Fed is onside in terms of short-term interest rates, but its third round of quantitative easing (QE3) is on the chopping block with further improvements to the U.S. economy. Still, fragility of sentiment and uncertainty among individual investors remain high.

Institutional investors worry less because most mutual funds get paid to buy stocks. Valuations are fair, given current earnings, and corporations have all the cash they need to maintain their businesses through continued economic mediocrity. Even if this upcoming earnings season turns out to be solid, the stock market should correct right after.

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