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Friday, March 28, 2014 - 14:30
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Friday, March 28, 2014 - 14:30

Is This Bull Market Approaching A Stop Sign?

Friday, March 28, 2014 2:30 PM

Over the past few quarters, there have been rumblings that the bull market is getting long in the tooth, and the time is at hand to shift more assets into cash.

To be sure, the direst predictions about the market have simply not come to pass. Yet the recent market performance may not be as impressive as you think.

As an example, though the Nasdaq composite index has staged some impressive mini-rallies in the past few quarters, it's really treading water. The day after Christmas, the Nasdaq stood at 4,167. Three months later, it has fallen to near 4,150.

The key concern is that a sideways market often portends a broader directional shift. The major averages get stuck in a range as buyers continue to pour funds in and a similar number of investors head for the exits. Often times, the buyers can get fatigued, and sellers start to take control.

To be sure, the market (as viewed by the Nasdaq) has been stuck in a few ruts over the past year and managed to reach new heights in subsequent months. But before you conclude that this is just another consolidation phase before the next upward move, take heed of several troubling signs that are emerging.

1. Cautious Outlooks
Over the course of the most recent earnings season, companies had a chance to set expectations for the year ahead. And often times, they sought to lower expectations. According to Bespoke Investment Research, more companies lowered forward guidance than raised it, creating a net 3.8% reduction relative to analysts' expectations.

One of the hallmarks of the bull market was a steady move to raise guidance above current expectations. That happened for nine straight quarters starting in early 2009. That trend changed in the summer of 2011 and has been increasingly negative ever since. Notably such tepid forward guidance was mostly made before the brutal winter took a toll on the economy. As a result, the odds of further bleak guidance in the imminent first-quarter earnings season are starting to increase.

2. Massive Insider Selling
Executives aren't merely talking down expectations -- they're backing it up with action. Nejat Seyhun, a finance professor at the University of Michigan, takes a clever approach to gauging insider actions. He ignores the moves made by major insiders that already own more than 10% of company stock. These "insiders" are usually major shareholders such as hedge funds, and their transactions aren't necessarily correlated with company-specific outlooks.

Seyhun instead focuses mostly on the actions of officers and directors at companies, and these folks have been on a massive selling spree. As Mark Hulbert recently noted in MarketWatch, Seyhun has spotted an alarming trend. The ratio of sales to buys by corporate insiders has spiked to 6 recently, which is more than double the 25-year average.

The takeaway is simple: If these insiders thought Wall Street was too pessimistic about upcoming sales and profit trends, they would sit tight. Instead, their actions likely reflect concerns that the forward view is not quite as rosy as many suspect.

3. Leadership Is Lacking
To use a military analogy, the soldiers follow the generals in the market. And over the past few years, leadership has surely come from the wave of new-era tech stocks. Yet these leaders have suddenly decided to stop leading... which is not good for the soldiers.

4. Eroding Investor Confidence
In about six weeks, we'll get a clear read on the latest actions from hedge funds and mutual funds as they update their quarterly holdings. In the interim, individual investors are starting to take a cautious view. Recent surveys by the American Association of Individual Investors (AAII) had noted a bullish tone, which appears to be evaporating. The percentage of investors in the bullish camp has moved down toward the 30% mark.

Bullishness is Waning

5. Massive Margin Debt
Individual investor sentiment is so important simply because many investors have borrowed heavily, taking up margin debt to leverage their gains in this bull market. But high levels of margin debt have exacerbated market routs -- in 2000 and again in 2008 -- simply because margin calls led to further waves of selling. This isn't an issue if the bull market only slowly fades, as investors can proceed to the exits in an orderly fashion. But a faster pullback in the market would likely lead to accelerated selling as margin loans are called.

Surging Margin Debt ($billions)

According to data provided by the New York Stock Exchange, margin debt surged 24% in the past year, which is not alarming by itself, as the market has also risen more than 20% in that time. But a market pullback starts to put that margin level out of whack, and as noted, can be a catalyst for more rapid selling.

Risks to Consider: The greatest upside risk is a resurgent U.S. economy. We may get a nice bounce-back in economic data this spring as a reaction to the brutal winter. But broader economic gauges, especially in the area of consumer spending, suggest we will remain in a sluggish long-term economy.

Action to Take --> Thought it's been said numerous times in the past few years, the impressive bull market is not due to a solid economy but instead to a stimulative Federal Reserve policy. As the Fed retreats, the market will need the economy to come through if it is to mark further gains.

Though investors have been conditioned to stay fully invested in this market, there are ample reasons to break that pattern and raise cash. As of now, there's no reason to expect a major market slump in 2014, but nor is there any sort of fundamental case for upside. That's why it pays to focus on stocks that have defensive characteristics such as strong free cash flow or a rising dividend yield.

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.