Is the market topping out? Technical and fundamental headwinds say yes

Numerous analysts have questioned the foundations of the current stock market rally, but the sagging economy hasn't stopped the rally from chugging into its ninth month. On Monday, the market charged out of the gate and held on to a three-digit gain all day.

Though the rally has ground down all who have dared bet against it, there are technical and fundamental reasons to suspect the rally is topping out -- not in a few months, but in a matter of days or weeks.
Technical Headwinds

Generally speaking, technical analysts don't attempt to tie the stock market's trends or fluctuations to financial fundamentals such as earnings, cash flow and revenues; they see the market action as reflecting the human psychology of greed, fear, complacency, confidence, and so on. As a result technicians ignore both bullish and bearish cases for the economy in 2010, looking instead for confirmations of the rising trend or divergences which may foretell a reversal in trend.

One technical metric many rely on is simple volume. When the volume of stocks traded is high, it's generally seen as a sign of conviction in either Bull or Bear. When the market rises or falls on low volume, many prognosticators view the move as suspect and not a real trend. Since August, volume has been very low in the moves up and much higher in the downturns. That suggests buying pressure is lower than selling pressure -- hence many use the term "melt-up" to describe the rallies since August.

Chart watchers also use indicators such as MACD (moving average convergence-divergence) and stochastics, which are derived from pure price action and plotted in two lines. When the lines cross, it heralds a trend change -- a buy or sell signal.

Both MACD and stochastics have been diverging from the uptrend in price since August; they have been slowly declining even as the market rose to new yearly highs. This is widely considered a warning sign that the trend is getting tired. Divergences can last a long time, but eventually they are resolved. Either the indicators start matching the price trend or the price trend reverses and aligns with the indicators. (If you're interested in technical analysis, AOL Money & Finance has a nifty charting system which you can use to plot various technical indicators.)

Fundamental Headwinds

Of course, there are other, fundamental reasons to question the current bull. Many observers feel the real economy has been diverging for months from Wall Street's rising stock market. A number of data points bring that point home, including:
  • Price-to-earnings ratios are historically high, suggesting stocks are richly priced.
  • With credit tightening and unemployment rising, two key supports of a credit-based consumer economy are still hurting.
  • Corporate profits have improved by cutting payroll and other expenses rather than by growing revenues.
  • The primary asset in most U.S. households, the family home, is still falling in value in most markets, slashing the equity (wealth) of the household and lowering its collateral for future borrowing.
Indeed, if we start with the basics -- that the U.S. economy is 70% consumer spending and that most consumer spending is debt-based -- then it is difficult to discern much hard evidence for the bullish case, as credit has tightened and consumers' income and assets have both plummeted. According to the Bureau of Economic Analysis, real disposable personal income (income adjusted for inflation and taxes) declined 3.4 percent in the third quarter after increasing 3.8 percent in the second quarter (the rise was due largely to payments from the federal government).

Sales taxes -- arguably the only trustworthy measure of real spending -- have cratered: down 10% to 19% in state after state. And income and corporate taxes have also dropped. For example, in Arizona sales tax receipts are down 14% and state income taxes are down 32%. These declines in sales and income taxes are terribly divergent from a stock market rally that is ultimately based on consumers borrowing to buy more goods and services.

And households aren't adding more debt to their balance sheets; instead, they're paying it off. Consumer credit decreased at an annual rate of 5.75% in August 2009; revolving credit (credit cards) decreased at an annual rate of 13 percent, and non-revolving credit (auto loans, etc.) decreased at an annual rate of 1.5 percent. The eight-month trend of falling debt is longest decline in consumer debt since 1991.

Even so, consumer credit (not including mortgages) is still around $2.5 trillion. Add in mortgages, corporate and government debt, and the nation's total debt exceeds 275% of GDP -- a staggering sum which far exceeds all previous totals of public and private debt and which suggests additional debt is simply unsustainable.

If consumers are expected to borrow more, we have to ask: based on what? Declining income and collateral? In an atmosphere of rising risk aversion, that is hardly the formula for new consumer borrowing.

Where's the Growth?

It's difficult to reconcile rosy outlooks for corporate profits with declining income and assets ($13 trillion has been shaved off household assets in the past two years), tightening credit, and consumers' new drive to pay down debt, not acquire more. And if corporate profits aren't about to rise sharply, then what's holding up stock market valuations? Some analysts tout growing exports as the future driver of profits, but exports are less than 10% of GDP and any rise in the beleaguered U.S. dollar would hamper a meaningful rise in exports.

The bullish case depends rather heavily on the notion that real estate has bottomed. While a case can be made that certain residential markets have hit bottom after declining 50% or more, by virtually all accounts, commercial real estate is about to fall off a cliff. How that supports the bullish case is not readily apparent.

Finally, though few are willing to risk mentioning this unhappy reality, none of the proposed "solutions" for health care in the U.S. actually cut costs by any significant degree. Since the nation expends some 16.5% of GDP on health care -- far more than any other industrialized nation -- this stupendous sum acts as a hidden tax on business and consumer alike. And even worse, health care costs continue rising at 6% a year, even as the overall economy is struggling and other prices are flat.

All of these factors act as tremendous headwinds to any sustainable rise in corporate revenues and profits, and are clearly divergent from the stock market's heady nine-month rally. Though there is no crystal ball that predicts stock market turns, the probabilities are rising that the divergence between Main Street and Wall Street will resolve in favor of the real economy, not Wall Street -- and sooner rather than later.

Charles Hugh Smith writes 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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