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Dow Jones Industrial Average Hits a Record

Industrials Graph - Past 20 Years

2013 has started off very strong for the stock market as money has started to flow into the stock market nearly four years into the rally from the post-crash low in March, 2009. For the first time in several years, money is leaving bond investments and flowing into stock market investments in quantity.

If you look back at the level of the S&P 500 Index at the March 2009 low, the index read 666 compared to today’s 1541. That is an increase of 131% – now is not the time to get aggressive investing in the stock market after such a big run higher. Looking at many of the indicators I follow, what I see is a stock market that needs to correct a bit as valuations have gotten somewhat stretched.

Please note that when I do my analysis, I use the S&P 500 Index to represent the stock market, not the Dow Jones Industrials. The S&P 500 is a much broader index and I think it represents the stock market better.

If you look at the chart that follows you will see a list of significant economic data points that compare where we are today in 2013 with where the economy was in 2007 when the DJIA was last at this level. These data points come courtesy of the Stanley Druckenmiller via Jim Cramer as quoted on Zero Hedge.

Economic Data Comparing 2007 and 2013

Our economy is significantly worse off today than it was in 2007 – but the difference is corporate earnings. The trailing twelve months earnings per share for the S&P 500 Index in 2007 when we were last at these levels was $84.92 with a P/E ratio of 17 compared to today’s EPS Estimates for the coming year of $97.70 and P/E ratio of 15.50.

It is clear today that in 2007 the stock market had gotten ahead of itself as the economic issues related to the the subprime mortgage crisis were just beginning to assert themselves. Investors were not anticipating the impact that such an event would have on the economy and corporate earnings. For the year ended in March 2009, at the bottom of the crash in stock prices, actual trailing twelve months EPS for the S&P 500 were $6.86 per share with a P/E ratio of 116.31.

In my opinion, we are not likely to see this deep of a drop in corporate earnings (from $84.92 per share to $6.86 per share for the S&P 500 Index) so I am not looking for a correction as huge as the 2008 crash – we should not expect the end of the world like we thought when the banks needed TARP and General Motors nearly filed for bankruptcy; however, the market as represented by the S&P 500 Index has moved up from 1,343.35 on November 16, 2012, to 1,541.07 today in a mostly straight up trajectory. This big move came in spite of a slowing economy, new manufacturing orders that continue to decline, and falling orders for non-defense capital goods.

I think the most likely scenario is that we correct back toward the November low – maybe not all the way but half to two-thirds of it – before the stock market moves back toward the current highs at year-end.

In the year-end Investment Commentary our clients received, I wrote that we were raising cash in client portfolios to protect against the financial risks coming from policy decisions (or failures to make decisions) by our government.

Even though we made it past the December 31 fiscal cliff deadline with tax and spending increases agreed to by our political leaders, and we made it past the sequester with $85 billion cut from discretionary spending, we still have two additional major fiscal events to deal with in coming weeks: March 27th is the expiration of the Continuing Resolution that has been funding our government in absence of an adopted budget; and mid-May brings another Debt Ceiling discussion as the country will again run out of borrowing authority once we reach the currently approved cap.

Given the fiscal issues facing our country, many of which are detailed on the chart above and combined with the various critical deadlines, it seems sensible to have an above average level of cash equivalent and short-term bond holdings in client portfolios when we get the inevitable correction so that we have cash available to reinvest in some of our favorite companies or funds at prices lower than today.

By raising cash on roughly 15% of our equity positions and locking in gains that we’ve experienced since the November low, and then subsequently reinvesting those proceeds later after the market corrects, we will be maximizing return and managing risk – two keys of successful investment management.

It is tough to not join the crowd as it is throwing money at the new high in the stock market, but as investors learned (or should have) in the past, it is better to be prudent and operate according to a plan – like one of my clients says on a regular basis “buy low sell high” as he pops into my office.

There is more truth to that kernel of wisdom than most investors understand – many of them sold out of the market in 2008 during the crash and only now are getting back in after the market has more than doubled. Our plan is to protect the gains we’ve earned since the March 2009 low so that we have cash available to reinvest when the correction comes; it is our plan to act wisely on that buy low sell high idiom and not follow the crowd that is buying at the top.

There is no date certain for when the market will pull back, but we will be ready with our list of companies to buy when it does. Famed investor Art Cashin was on TV today stating that from a historical perspective that markets very often act in a self-fulfilling prophesy manner when nearing new highs as investors come off the sidelines to add money to stock positions only to see a correction shortly thereafter.

As I look at many of the indicators I follow, I see a market that is weakening in spite of new highs. These indicators give me a feel for how the market is reacting internally separate from the price action of the index.

Check out the chart of company trading above their 50-day moving average:

above-50-day-sma

Notice how it has rolled over and there are now significantly fewer stocks trading above their 50-day moving average – and see how we have fallen below the upper threshold we have held for so long as the market moved higher.

Now, take a look at the graph of stocks trading above their 200-day moving average:

above-200-day-sma

This is a more intermediate term sort of indicator, but you can see that it is also rolling over and showing that stocks are weakening.

The next chart is the Bullish Percent Index – you can see that it has been jumping above the upper threshold for sometime indicating too much bullishness (its a contrary indicator – when too many people are bullish, that means its time to get conservative) but is also rolling over.

bullish-percent-index1

This chart is of the Hi Lo Index and shows you the number of new Highs versus new Lows in stocks.

hilo-index

You can see that it has been above the upper threshold for a long time, indicating caution, but that in spite of the market at current highs, the indicator is rolling over and showing weakness.

And our final chart is of the VIX volatility index.

vix

You can see that this indicator is trading below the lower threshold (the upper one does not even show on the graph in this view) which tells you how complacent the market has become). Investors have become accustomed to the market going up, so there is no fear – this is a big contra-indicator and for me is always a reason to go against the grain.

So, based on the fundamental analysis that shows our economy in much tougher shape than it was back in 2007 when the stock market was at this level, based upon the political uncertainty in Washington relative to how we will fund our government and how we will reorganize our fiscal picture so spending and revenues are more in line with each other (stock market investors hate uncertainty and tend to lower P/E valuations because of it), and based upon the weakening internals of the stock market in the face of new index highs, I am very comfortable with an above average level of cash and short-term bonds on hand as a risk management tool.

I will be writing to you soon about some of the companies we are looking to add when the market correction arrives. We are focused on strong earnings growth and quality balance sheets, and I will detail for you some of the analysis we perform to select our holdings.

Until then, we will be monitoring our indicators and possibly expanding our cash and short term bond holdings if the market meanders higher.


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Mark