The rip-roaring market ascent since late August has been breathtaking, but has hit a bit of a roadblock of late. Is this a breather or the start of something more sinister? No market ever goes up in a straight line without some sort of pullback or pause, but I feel that there is a bit more pain for the bulls before the market advances again. I will provide three reasons.
1. There are still too many bulls out there as measured by the AAII Investor Sentiment Survey. As of last week, 57.6% were bullish, up 9.3% over the past week. This is way above the long-term average o 39%. This means that there are too many investors that expect the market to keep going up. History has shown that extremes in market sentiment point to the market going the other way. The number of bulls must decrease for the rally to continue in earnest.
2. The market has changed character over the past week. Every single rally has failed and the dips have not been bought. During the market’s rise, the bulls were like Pavlov’s dogs buying the dips every single time like clockwork. A sign of a bullish market is how it acts when it is down. Lately, the dip buyers have been absent and the selling has picked up in intensity. When the dip buyers become hesitant, it means more downside is in store.
3. A lot of the positive from the past two months have been priced into the markets already. The biggest piece of news to be priced in is the Fed’s second quantitative easing plan. There has been huge resistance to the plan from foreign leaders and most recently several Republican lawmakers. More importantly, the dollar has actually been rallying as have the yields on treasuries. The fact that these are happening shows that investors are doubtful of the effects of QEII.
What To Do
So what does this all mean? I would recommend to proceed with caution until the complacency lessens a bit. We need to have a bit more fear in the markets before it can go up for a prolonged period again. If you have some big profits in riskier stocks, it might be a decent idea to protect those gains by selling or at least buying protection in the options markets via puts. Of course I could be wrong and the market could soar to new highs without anymore downside, but the market action says otherwise. It would be wise to pay attention to it.
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