Is this 2007….all over again?

The S&P500 inched up another 1.4% last week, on decreasing volume.  While the VIX (or fear) index barely changed for the week, two important points need to be made.  First, the VIX is scraping along near the bottom of its historical range.  This is a level that’s always associated with complacency and from which price pullbacks, minor or severe, usually begin.  Second, the Fed’s money creation artificially pushes down volatility, because it acts as the writer a put option on the stock market.  This causes other market participants to avoid buying as much insurance against price drops as they otherwise would buy.  The result is that the VIX has less relevance than it does when QE is not taking place.  So after QE ends in a couple of months, expect the VIX to surge in importance.

There weren’t a lot of economic releases last week.  Consumer credit rose more than expected, but with the number of employed people at or near cycle lows, and with the 99 week unemployment program spitting out hundreds of thousands of people every month, a plausible reason for the credit jump is that folks are borrowing more just to make ends meet.  Not a healthy reason for consumer credit growth.  Initial jobless claims dropped below 400,000 but the unadjusted claims level is still in the mid-400,000 range.  Finally, international trade results were slightly worse than expected; we’re importing more than we export, and this unhealthy–and unsustainable–activity is not getting better, as it should.

Technically, since the stock market continues to correlate almost perfectly with the Fed’s QE program, traditional analysis is less relevant.  The stock markets melt up, as long as the Fed keeps printing.  Period.  Soaring commodity price inflation, revolutions in the Middle East, and near-record unemployment levels in the US hae been no match for the Fed……so far. 

So unless some “shock event” can overwhelm the Fed’s monetary fire-hose, then the world will wait to see how well the risk asset markets can stand on their own when the Fed stops QE2 in a few short months.

But what to do in the next 60 days?  Should new money be “put to work” in the US stock market? 

David Rosenberg of Gluskin Sheff (and formerly Merrill Lynch) puts it bluntly: “sorry, but that time has passed.  But we will probably get another kick at the can because we are sure that the “event risk”, which caused so much turbulence and buying opportunities in 2010 will come around again in 2011.  But this is one overextended US stock market, that is for sure.”

David then neatly highlights some key metrics comparing the stock market today to the market at other fully valued times:

1. The S&P500’s dividend yield is 1.8% with a 10 year Treasury yield at 3.7%.  This dividend yield is exactly where it was at the market peak in October 2007.

2. The cyclically adjusted P/E ratio on the S&P is now 23.3, exactly where it was in May 2008, well before the massive market meltdown occurred.

3. The Investor Intelligence survey now registers 53% of market participants as bulls and 23% as bears.  At the March 2009 lows, these figures were reversed.

4. Equity money managers report only 3.5% cash ratios.  The last time they had so little cash available was in September 2007, about a month before the peak.

5. At the March 2009 lows, economic indicators like the ISM were at 36, meaning they could only rise.  Today, at 61, they are much more likely to fall than to rise.   

So the bottom line is this: today is NOT a great time to put new money to work in the stock market.  If you do, you’re essentially betting that you can capture some more upside for the short time that the Fed will keep propping up the stock markets.  You’re also betting–like pretty much every pro in the business–that should some shock event shove the market down before the Fed ends QE2, that you’ll be the first to escape out the exit door.

Reality is not so rosy.  When the market turns–especially when it’s overextended–almost all of the pros (and especially the retail amateurs) will NOT get out in time.  In almost every major downturn, the pros get burned….badly….and seek solace in the “hey everybody got hurt because nobody saw it coming” excuse.

We can see it coming.  Don’t get burned. 

Unless you run a high frequency stock trading scheme, you should approach the stock market as you would a marathon.  Don’t try to sprint out of the gate looking to clock the best time at every mile.  If you do, well before you ever reach the finish line, you’ll die from a heart attack.

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