News Analysis date published New: 
Friday, October 5, 2012 - 13:00
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Friday, October 5, 2012 - 13:00
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Friday, October 5, 2012 - 13:00

5 Reasons the Market is Ripe for a Pullback

Friday, October 5, 2012 - 1:00pm

To the casual observer, it must seem as if the market has been trending in only one direction -- up --since bottoming out in March 2009. A gain of more than 100% in the S&P 500 since that bottom surely gives the impression of a bull market, one that appears to have perked up in recent weeks and months.

But the market doesn't actually move in a straight line, it moves in waves as investors take a herd-like mentality to buying and selling phases. Though the S&P 500 rose an impressive 81% from the March 9, 2009 intra-day low through April 2010, here's what's actually transpired since then...

Solid upward moves have invariably been followed by double-digit pullbacks. Some might suggest that the upward moves of 81%, 33% and 27% between April 2010 and March 2012 mean that the current 15% gain from early June suggests more upside before the next pullback. Yet these rallies are coming on ever-higher levels for the S&P 500.

Simply put, it was easy for the S&P 500 to show solid potential upside when it traded at 700, 900 or 1,100, but the current 1,462 level means this is no longer an underdog market. And those double-digit pullbacks noted above: They all took place in a matter of a few months. In effect, the market can go down a lot faster than it goes up.

I took a bullish stance to this wave action back in early June, noting that it was time for investors to take advantage of the recent 11% pullback and focus on a half-dozen market positives. Indeed the market ended up putting in a seasonal low just a few days later.

Now, with the subsequent 15% gain, which works out to be a 45% move on annualized basis, it's prudent to think about what could go wrong in the months ahead. Serious hurdles remain in place, which the market has ignored in recent months, but the market's mood can change on a dime.

Here are five reasons to be increasingly distrustful of this rally:

1. Earnings season to the rescue?

As the earnings season kicks off, we may be looking at the first quarter of negative year-over-year profit growth since the first quarter of 2009. In fact, it would be the first time that earnings turned negative -- outside of a recession -- since the Asian financial crisis of 1998. Analysts currently expect aggregated earnings for companies in the S&P 500 to fall 2% from the third quarter of 2011.

Bulls will correctly suggest that analysts steadily lower the bar until it's beatable, implying we won't actually see profits dip once companies deliver the usual "beat by a few pennies" game that often plays out. True, but it's what companies will say about forward outlooks is how investors will really respond, and it's getting harder to see why a company would be bullish about the fourth quarter and early 2013 after considering these next data points and concerns.

2. Europe is getting worse

The market has been relieved that European policy makers have shown more resolve to keep Greece, Spain and others from falling into the abyss. This is truly a welcome development and greatly reduces the chances that the United States will be dragged down in some sort of global economic maelstrom. But Europe is still sick -- and getting sicker. Regionwide unemployment stands at 11.4% and rising. And that figure vastly understates things as a number of the "employed" are only able to obtain part-time work.

High unemployment increases government benefits spending, exacerbates social tensions and leads to reduced government revenue as fewer taxpayers can contribute to the system. The ability for these governments to reduce stubbornly high budget deficits becomes more implausible as long as the economies such as the United Kingdom, France and Spain remain in recession.

3. Washington's last-minute moves come too late
The "fiscal cliff" that many are thinking about will eventually be tackled. It's hard to see how lawmakers will fail to act once the crisis stares them in the face. Yet the delays in taking action are already having an effect. Surveys indicate that companies are increasingly hesitant to spend on discretionary investments in light of the mere possibility of the fiscal cliff coming to pass. In fact, that's likely to be a frequent topic for discussion on upcoming conference calls this earnings season, which is bound to spook investors.

4. The downward sloping PMI
The purchasing managers' manufacturing index (PMI) is the best gauge we have to see the level of activity on our factory floors. The number has been above 50 for several years, implying the manufacturing sector is expanding. Yet the reading has weakened, and can sometimes be an early indicator of an eventual recession. A move below 50 may be troublesome for stocks, and we'll get fresh readings in late October and again in late November. The recent trend is hardly encouraging.

5. Taxmageddon is coming

Earlier, I noted that the delayed response to the looming fiscal cliff is sapping business confidence. Though that may seem like a short-term factor for businesses as legislators will eventually come to an agreement, it's what they end up doing that really determines the course of the economy. Here's what we know: The government spends much more than it earns, which means lawmakers will have to figure out ways to shrink spending and raise revenue. Few have fully grasped what higher taxes will do to consumer spending.

Even if lawmakers don't raise tax rates, the mere expiration of many "Bush-era" tax cuts will be a tax hike for some. Letting the fiscal cliff come to pass means a 3% to 4% drag on the economy (in terms of growth domestic product), but even a solution to that looming draconian plan in the form of a closing government budget gap still equates to at least a 1% to 2% GDP drag. Can we afford that? And can companies really boost profits in 2013 if the economy doesn't grow at a reasonable pace?

Risks to Consider: The main catalyst for ever-rising stock prices has been a lack of scary news that has enabled investors to focus on the positives. So as long as all of these issues stay in the background, the market can indeed move higher.

Action to Take --> This rally feels as if we're living on borrowed time, especially when you consider that stocks are right back at their pre-recession peak, even though the global economy is a lot more troubled than was the case in 2007. Please continue to take caution in this market. History has shown that you may have more compelling buying windows after the next inevitable wave of profit-taking arrives.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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