When discussing the financial markets with fellow investors, I am often asked, "What book has had the most impact on your investing philosophy?" Without hesitation, I answer, "Triumph of the Optimists."
This 2002 book isn't a how-to on investing or trading. Rather, it's a treatise on the investment returns over the entire 20th century. The book has had a profound effect on the way I view the stock market. This little-known book radically altered my thinking from focusing exclusively on narrow short-term results to a broad-based long-term view.
In other words, it has allowed me to see the forest rather than just the trees. It is through this prism that I feel confident in making this bold market prediction.
"Triumph of the Optimists" looks at 101 years of global investment returns and teaches what is, to my thinking, the correct way to measure returns over time. What I found most profound is that from 1900 to 2000, in terms of returns, stocks thumped bonds, and bonds beat cash. Remember, this is despite sharp downdrafts across the board in worldwide markets.
Other interesting facts include the reality that value stocks beat growth stocks from 1926 to 2000. In addition, in the U.S. and U.K., reinvested dividends would account for close to half of the total stocks' annualized returns.
However, the authors were very cautious in making predictions. The book implies that the optimists will not continue to triumph in the 21st century, due to the equity risk premium. Clearly, the authors did not foresee the booming stock market, financial system breakdown and the massive intervention by the Federal Reserve, which has acted as a catalyst to push stocks to record-smashing heights this year.
Despite the authors' caution, their arguments turned me into a super-bull on the stock market.
While this is my overriding market philosophy, I strongly think the short-term top is in place in the U.S. stock market for the rest of this year. This belief is not in conflict with my overall long-term bullish nature.
As "Triumph of the Optimists" illustrates, markets never go straight up forever. There are always declines and occasional sharp drops during long-term bull markets.
These declines provide opportunities for savvy investors to buy stocks at discounted prices and ride them to wealth over the long term. I am not alone in my proclamation that stock growth has come to a short-term end . StreetAuthority co-founder Paul Tracy thinks we have entered a period known as the "dividend decade" with all returns being attributed to dividends rather than market growth.
When you consider that 50% of all stock market returns can be attributed to dividends during the roaring 20th century, this scenario isn't too hard to imagine. Here are my reasons for proclaiming the market top is in place for at least the rest of this year.
|1. The End Of "Easy Money"|
|As a result of the financial crisis, the Fed embarked on a historic quantitative easing (QE) stimulus program to keep the financial system afloat and jump-start the economy.
Most recently, this program involved buying $85 billion in bonds a month. While the results of this unprecedented intervention have pushed the stock market to all-time highs, the intervention cannot continue forever -- and it appears that the end of easy money has been signaled.
On June 19, it was revealed that the Fed is considering pruning the stimulus starting in September. Just this hint sent the stock market sharply lower by more than 2%. Prior to the Fed's hint, the benchmark S&P 500 has given back 4.6% since its May 21 high-water mark due to speculation of the stimulus ending.
Now, the speculators have solid evidence of the Fed's potential move. While the fear has diminished concerning the end of quantitative easing, with the Dow Jones Industrial Average bouncing back to its 50-day simple moving average at the start of the third quarter. Speculation about the end of the Fed's open-ended easing policy should continue to provide strong headwinds against a new high in the DJIA.
Even the International Monetary Fund is warning about ending the QE measures, saying that a poorly planned or abrupt exit could have "adverse global implications, including a reversal of capital flows to emerging markets and higher international financial market volatility." All investors, particularly emerging-market investors, need to be aware of these implications.
|2. The Volatility Is Spiking|
|The CBOE Volatility Index (VIX) has climbed 67% from its 72-month low in March. On June 20, the index spiked more than 20% in one day alone.
The index is designed to measure the expected volatility in the S&P 500 over the next 30 days. It is also called the "fear index" because the higher the index moves, the greater the fear of a pending market correction.
|3. Rising Interest Rates|
|Interest rates have started climbing. There is little that can stymie a bullish stock market as much as the fear of interest rate increases. As the economy begins to transition away from direct Fed intervention, interest rates will most likely continue to climb, resulting in adverse conditions for the stock market.
|4. Earnings Fears|
|Pending second-quarter earnings warnings have outstripped positive forecasts 6.5 to 1. This would be the most bearish ratio in the past 12 years. Weak corporate earnings results, combined with the headwinds of the Fed likely turning back on the spigot of easy money, may weigh heavily on stocks as big-money players jockey to dump their equity holdings.
|5. The Technical Picture|
|As you can see from the above daily chart of the Dow, the price has formed a double top near the end of May and plunged to the 50-day simple moving average support line. The Dow tried in vain to break higher, but the worries of higher interest rates and Fed easing ending kept the yearly May highs in place.
Finally, the Fed mentioned ending the QE measures, sending the Dow sharply lower and breaking the long-term support line at the 50-period moving average. The next solid technical support level is the 200-day simple moving average, about 800 points lower.
Risks to Consider: Although I think all the signals are pointing to a significant market correction, anything can happen, so be cautious in attempting to time the market top.
Action to Take --> Market corrections create opportunities for investors to buy quality stocks at bargain prices. In addition, it is critical to remember that even during market corrections, there are individual stocks and groups that continue to outperform. It is possible to profit on the short side of any decline, but shorting is suitable only for investors who understand the risks involved. It is important to note that even if this pending correction is severe, history shows that we can expect new all-time highs within the next decade.