I have been raising cash for a few months and now hold significant cash balances for portfolios. Stocks have continued to advance this year, after the Fiscal Cliff debates resulted in a somewhat palatable solution, at least, it appears, palatable to many investors, even if not to me. Today stocks have pushed the Dow to a new all-time high. From a technical analysis perspective we will need to close above the old high close – around 14,162 – for at least 3 trading days in a row for this break-out to be validated. If stocks stay above this level, we could see markets trade up into a new, higher trading range. However, the broader market (S&P 500 and NASDAQ) have not made new highs – at least not yet. The S&P 500 is very lose to a new all-time high, currently trading around 1,540, it is only 25 point from the current all-time high. The NASDAQ, currently trading around 3,220, is about 2,000 points from its all-time high, set back in 2000 at the peak of the tech bubble.
The S&P 500 could certainly make a new all-time high here in the next few days, if stocks continue to rally. Euphoria over the Dow’s advance, short of any negative news, could be enough to get the S&P 500 over that hurdle. While there are a host of fundamental reasons – valuations, corporate profits, GDP growth, economic challenges, etc. – to believe that stocks should not go higher, as long as investors are willing to pump new money into stocks and stock mutual funds, we will see higher levels for the indexes. Small investors are certainly driving the current market rally. We have seen clear signs of 401(k) cash balances, which were exceptionally high at the end of 2012, drop significantly this year, as these investors, who largely missed the gains of 2012, scramble to catch the tail end of this bull run.
Small investors, as we well know, are almost always wrong and are late to the party – late to get in and late to get out (much more damaging). In addition, we have bond investors who, desperate for yield, are assuming more risk than they are comfortable with, to replace current income that they can not get in bonds because rates are so low. These investors are fickle and will be the first to jump ship when things start to look uncertain. Combining small investors’ tendencies to overreact and panic with bond investors who own stocks out of desperation, and you have the underpinnings of a serous correction. Downside for the Dow in the short-term is to about 13,000. A “normal” correction, which would not break the bull trend to that level would mean roughly a 9% correction from current levels. If we broke below that level, the bull trend would be broken and we could go a lot lower – perhaps twice that amount, or down in the 11,500 to 12,000 range.
I personally look for a 20% correction, although it could be worse than that, depending on how much higher we go. Don’t forget that, in addition to the sequester spending cuts, which are already weighing on the economy, we have the debt ceiling debate coming up. The GOP has drawn a line in the sand on spending cuts and on additional tax increases. Obama doesn’t have the votes to overcome their position, so he will be forced to give in on entitlements. While this is what we have to do (we will probably also need to close a lot of the tax loopholes as well, which will give Obama a hollow victory he can claim for political purposes), the impact on the economy and corporate profits will likely be dramatic.
Another major 800 pound gorilla in the room is the Fed’s stimulus program, which will end this year. They are spending $85 billion a month to try to hold long-term rates down (the sequester spending cuts are only $85 billion a year). When this spending ends, rates will jump and the cash that has been flooding into the economy as a result of their buying will stop. We have to stop spending that money, especially when we are having to cut spending on so many government programs. If we combine all of this – the sequester, entitlement spending cuts, tax increases, and an end to the Fed’s stimulus, the result will be significant enough to push the economy back into recession. We were only at 0.1% annualized growth in the fourth quarter before the payroll tax holiday ended, before the tax increases on the wealthy, before the sequester cuts, before entitlement cuts, before more tax increases and tax loophole closures, and before the Fed’s stimulus ends. Where will GDP be after all of this takes effect? I can’t see how we can avoid another recession.