Ten reasons to beware the Bear

I'm wary of both extreme euphoria and gloom because they reflect emotion more than reality. For instance, a mere three weeks ago, the financial media was chock-full of stories warning that the stock market was about to suffer a dramatic decline due to an ominous "head and shoulders" pattern in the S&P 500's chart. Instead of declining, the markets rocketed up for three straight weeks, with the S&P 500 topping out last Friday at 1,010. (For the record, I went long on July 9th and explained my reasoning on my blog, Of Two Minds.com.) So much for widespread gloom being an accurate predictor of stock market action. Rather, such extremes of sentiment are remarkably accurate contrarian indicators.

When gloom and fear are absolutely pervasive, conditions are ripe for a reversal-that is, a stock market rally. Gloom also reigned supreme in the first week of March when the stock market reversed its panic-stricken drop that began in late 2008.

Now we find the exact opposite emotion-euphoria-is pervasive. Standard-issue financial pundits (SIFP) are falling over each other in their eagerness to declare a new Bull market, the end of the Great Recession, financial stocks are dirt-cheap, etc. All this confident euphoria is driving the contrarian meter off the scale, creating an ideal setup for an "unexpected" return of the Bear-not just a modest retrace or correction most expect but a sharp, unrelenting decline.

There are a number of technical indicators that suggest the 1,010 level on the S&P 500 is not merely a way-station on a great glorious Bull market, but the top of a five-month uptrend. You've probably read about these indicators already, but it may prove prescient to ponder the entire list:

1. The rally is getting long in tooth. Technicians have long noted that rallies and declines tend to last 60, 90, 120, 150 or 180 days. The end of last week marked day 150 of the rally from March 6, and while it is possible it may run another 30 days, it is already one of the longest rallies on record.

2. The market tends to top in late July or early August, especially in the first year of a presidential cycle. Nothing is written in stone, but this is worth noting.

3. Bullish sentiment is at contrarian/reversal highs. Most measures of sentiment are in nose-bleed territory, and at least one spiked sharply after July 23.

4. Volume has been declining during this rally. The cliché is that "volume is the weapon of the Bull," and this truism has been supported by history. Low-volume rallies are suspect, and this one is not just low but declining in volume.

5. Valuations are extremely high. The price-earnings ratio (PE) of the S&P 500 is somewhere north of 140, quite a bit higher than the average of 14 and Bear Market lows around 7.

6. Insiders are selling like crazy. The ratio of insider buying to selling transactions is 5 to 145, and the buys--$13.4 million--are pathetic compared to the Sells: $1,042 million. Hmm, what do they know that the rest of us don't?

7. The S&P 500 and the Dow just hit key technical resistance. Many traders look to Fibonacci projections for guides to future action and the S&P 500 and Dow just reached the 38.2% retrace of the entire move from their Oct. 2007 highs to their March 09 lows.

8. The dollar and stocks have been on a seesaw. Regardless of "why", the U.S. dollar and the stock market have been on a seesaw all year: when one touches bottom, the other is topping out. The dollar hit bottom last week, so... the picture darkens for equities.

9. Highly speculative companies are soaring. When stocks of visibly risky companies start shooting to the moon, that's often an indicator the rally has reached a bubbly level of speculative excess, which is typically followed by a hard fall.

10. Stocks have been rising on excess liquidity, not investing. The Federal Reserve has been pouring billions of dollars of liquidity into the financial system at near-zero rates of interest, thus tempting money managers to put money to work in the stock market. The U.S. stock market has increased about $2.7 trillion in value, yet only $400 billion has been shifted out of money market funds into stock funds. This "hot money" doesn't sound like a solid foundation for the rally.

Nobody knows the future, but it may pay to be cautious for the next few months-historically, the worst months for stocks, surpassing even October.

Charles Hugh Smithwrites the Of Two Minds blog and is the author of numerous books, most recently "Survival+: Structuring Prosperity for Yourself and the Nation."
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