Long-time readers, listeners as well as clients already know how I feel about the current U.S. stock market bull. For example, the absence of revenue growth at corporations (e.g., average sales growth for Dow components in 2013 is -0.7%) and the exceptionally high cyclically-adjusted P/E (i.e., 25) do not matter right now. And that’s okay. Pending home sales have dropped for five straight months and mortgage applications have declined for 5 consecutive weeks, placing a potential damper on the real estate recovery. That’s okay too. Not to be outdone, bearish sentiment by investment advisors, a well-tracked contrarian indicator, has plunged to its lowest level in a quarter century (14.3%). That’s fine as well. In other words, as long as the investment community believes that Federal Reserve maneuvers will benefit equity risk-taking, it is sensible to participate in the easy-to-identify uptrends.
On the other hand, let me present a hypothetical scenario whereby the Dow at 16,000 rises to 20,000 over the next 12-24 months. Should the 25% price gains occur, even the most strident bulls would recognize the historical probability of a stock bear emerging after 6-7 years of upward movement. It follows that those 25% gains would be wiped out in a buy-n-holder’s account if a 20% bear came to the picnic table. Moreover, with the average bearish erosion at 30%, a Dow Industrials that reaches 20,000 might see 14,000 before it sees 24,000.
The point here is not to discourage ETF advocates from participating in the Fed-fueled rally. Rather, the point is to drill home the notion that, at this point in the cycle, you cannot afford to buy-n-hold your stock assets.
Fortunately, there are a number of simple ways to determine whether it is time to lighten up. One of the most basic methods? Bolster your cash account if the price of the SPDR S&P 500 Trust (SPY) breaches its 200-day on the downside and fails to bounce back quickly. You could sell a small portion, a large portion or the whole kit-n-kaboodle. Just be certain to be consistent with your personal discipline for reducing risk.
Decisions based solely on trendlines are far from perfect. Nevertheless, they’d have helped you avoid the bulk of the 2000-2002 bear, the panicky portion of the 2008-2009 collapse as well as provide a measure of comfort during the extreme price swings in the 2011 euro-zone crisis.
Recognizing that bull markets differ, however, it is worthwhile to examine the current bull rally in the context of Federal Reserve intervention. In fact, the last two year’s worth of gains are primarily attributable to the Fed’s ultra-accommodative approach. That is why I look to several influential ETFs for additional clues. For instance, the Fed’s orchestration of the “wealth effect” with the phenomenal rise in home prices now increases the importance of watching the Homebuilder ETFs. The iShares DJ U.S. Home Construction (ITB) is already flashing a warning sign, whereas SPDR Homebuilders (XHB) has been a bit more resilient.
Some emerging market ETFs can also assist investors identify if they might need to reduce U.S stock exposure. This is because a number of emergers are particularly dependent on foreign capital to help fund their deficits. It follows that if the Fed signals an ongoing plan for reducing its money printing, as opposed to a one-time, data-dependent gesture of lowering the dollar creation from $85 billion to $75 billion, I would expect WisdomTree India Earnings (EPI) to fall back below its 200-day trendline. Right now, though, EPI’s momentum is a sign that “cheap money” may be around for quite some time.
Last, but hardly least, keep an eye on the iShares 7-10 Year Treasury Bond Fund (IEF). A price movement below the September lows would likely correspond with a 10-year yield closing well above the 3% mark. The U.S. stock market is currently pricing in a 10-year between 2.5% and 3.0%, and not much more.
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