Getting Closer to a Drop

The large company portion of the stock market has continued its upward trajectory. The Dow is still the headliner, having reached another new high plateau last week. I told you on April 30 to expect a higher market in the short term, with trouble happening in the medium term. Evidence supporting that scenario keeps appearing.

While the housing market has shown no street level evidence of cracking, the story of its demise has been reported for years now and continues to get ink despite its falsehood. There’s a chance that it will begin finally pulling back. Let’s put it this way: it’s gone only up for the past five years. Odds are that it’ll take a break eventually, though I don’t expect a crisis. In fact, I hope it corrects to the tune of 30% so I can buy property on the cheap. More on that in this week’s letter.

Housing could correct just as the dollar finally gives way and gets much weaker against the euro and yen. This, too, has been widely predicted for years but hasn’t hit nearly as dramatically as expected. The yen, much to my disappointment as a holder, remains weak against the dollar, stuck in the 115 to 122 range. What if the dollar starts dropping as oil stays expensive and house prices fall? What if the rest of the world decides that holding dollars doesn’t make sense, and starts dumping them in favor of a diversified account? That could send stocks lower.

The final bearish point is inflation. Careful readers know that the Fed is worried about it, and has been for the past year. The annual rate is still above the Fed’s 2% comfort zone limit. Even postal rates are going up. We are not likely to get an interest rate cut soon and some still think we’re in for another rate hike. Staying the same for a while appears probable, which will not help relieve the summer doldrums. The dollar’s gradual decline contributes to inflation by making foreign goods more expensive. A suddenly crashing dollar would send inflation spiking in a one-two punch few would care to take on the financial chin.

I rarely state the bear case because I’m a long-term bull. Any student of the market becomes a bull for the long term because the market rises over time. I’m not at all afraid of these factors.

What I know, however, is that they can take center stage for brief periods and control the collective psyche into a sell-off. That gives us a chance to buy on the cheap, which I’m hoping to do in the medium term.

For now, though, all is cheery. That’s keeping the market going higher in the short term.

Signs of a top are adding up. Breadth in the market has narrowed. Advancers and decliners are coming in about even. A smaller group of stocks are leading the averages higher, but the larger market is showing that it’s done for a while.

Insiders are selling. While not a screaming negative because people sell for a lot of reasons that have nothing to do with the valuation of what they own, it would be more encouraging to see them buying at these levels. It looks like the people in charge of racking up profits in corporate America think the best place for their own earnings is a bank account, not shares of their companies.

Also, right on cue, investors are becoming more bullish as the market rises. This is a negative sign because they get bullish as their money gets invested and they hope it rises. When all the money is invested, there’s no more money to buy so prices begin falling. Investors Intelligence reported in its most recent survey that bearish advisors now comprise just 20% of the market while bullish ones comprise 53%. The CBOE put/call ratio is down at 0.57, a worry-free level. Many more people are betting on a rise than a fall, making a fall more likely. Back in mid-March, for instance, it was above 0.80%. People were betting on a market fall when it was poised for a sprint higher. Now that it’s much higher — a record high for the Dow — people are more positive.

Looking carefully at professional money managers, I can’t help but notice that even the professed bulls have a large portion of their money in foreign markets. They’re guarding against a drop in the U.S. as they speak glowingly of the market’s prospects.

All in all, my forecast of a rising market in the short term followed by a falling one in the medium term seems to be on track. I’ll be looking to get limit orders in place under some of our individual positions, and will consider opening a hedge position.

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