Too Many Red Flags To Ignore

As we approach the holiday season, it reminds us that the end of the year is coming as well.  With only one month to go, it’s a natural time for investors to start to tally how they’ve fared in this difficult environment.  Some were spooked out of the market in late 2008 (with good reason) and have missed out on the entire rally.  Some, have just hung in there.  They rode it down and have ridden it back up.  While others have navigated pretty well.

But, with the new year on the horizon, fund managers, hedge fund managers, & individual investors have begun making adjustments to their portfolios.  As they do this, it’s important that we follow the money.  Over the past 10 days, the S&P 500 has struggled to go and stay above the 1110 level.  Why is this?  Isn’t the economy continuing to improve.  As you recall, the stock market is highly correlated to how fast the economy is recovering.  Up to this point, the economy was recovering at a faster and faster rate each month.  That may be behind us.  It’s not to say the economy won’t keep improving, but it may not be fast enough to sustain higher equity prices (Flag #1).

Bull markets go through many stages as they mature as I’ve discussed in previous blog posts.  I believe we are firmly in stage #2 which means much more selectivity on the part of investors.  There is profit taking, less enthusiasm for stocks, and more scrutiny.  This explains why some of the leaders of the rally since March (i.e. Goldman Sachs) have begun to lag and companies with excellent balance sheets that have lagged (i.e. Disney, Wal-Mart, & Coca-Cola) are now leading.  Having the mega large cap stocks lead a rally isn’t the worst thing in the world but it definitely tells me the character of the market has changed (Flag #2).

Let’s move to some of the technicals.  A healthy bull market is one where more and more sectors and stocks are participating.  That was the case up until about a month ago.  Now, what you are seeing is the complete opposite.  Less and less stocks are participating in the rally and the big caps are doing the heavy lifting.  Remember that most of the indices are cap weighted meaning the bigger the company, the more points they are awarded in the index.  That’s why when big caps go up, the indices go up (Flag #3).  Another healthy sign in a bull market is when there are more and more companies making new highs.  That has peaked as well.  So, the number of companies blasting through their old highs is dwindling (Flag #4).

I’m also noticing that there just isn’t the demand for stocks there was a few months ago.  Most of the up days are because sellers are pausing or resting waiting to sell at higher prices.  The demand is not there right now (Flag #5).

These flags don’t mean we have peaked.  In fact, the indices could keep making new highs for several more months.  But, when there are this many red flags and we’ve advanced as much as we have since March, you better start thinking of exit strategies.  This could simply be a major pause in a longer-term bull market.  But, given the headwinds in front of us (deficits, rising taxes, potentially rising interest rates, etc.), my bet is that 2010 will be a much different year than 2009 and this is the time to start preparing.

Happy Thanksgiving everyone!  Thanks for your support.