Equity Markets are Stretched

The S&P500 crept up slightly last week (up 0.38%) on light volume. And volatility dipped just a bit, taking a complacent market into even deeper complacency. Corporate sales and, more importantly, earnings are weakening, yet equities are shrugging off any concerns, and instead are implicitly projecting that record high earnings (as a percent of sales and as a percent of GDP) will continue into the future…..indefinitely.

Economically, the US continues to struggle. All leading economic reports are suggesting that Q4 2012 GDP will come in at the weakest rate since the Great Recession started. Last week, while light in the number of reports, was also not positive. Initial jobless claims came in worse than expected. International trade was far worse than forecast; this will translate into a direct hit to GDP.

Meanwhile, as US fiscal policy has officially switched into DE-stimulus mode, US monetary policy continues to pump 80 billion, or so, of dollars into the asset markets each month. But as Ben Bernanke stated a month ago, if Congress allows large spending cuts to take hold next month, then the Fed will NOT be able to offset the full impact of this additional fiscal penalty.

Technically, the US equity markets are now in uptrends, both on the daily and weekly charts. There’s one major problem–and risk–with this however. The stock markets are extremely overbought and overly bullish. The Fed has truly convinced the US equity markets that nothing, absolutely nothing, can go wrong with stock prices. Corporate earnings can fall. Euroland sovereign credit crises can erupt. Japan can teeter on the edge of fiscal insolvency, and China can continue to artificially prop up its economy. But US stock investors should pay no mind to such risks, because the Fed will have their backs covered.

This condition, the state of supreme complacency and one-sided conviction that nothing stock prices cannot go down, is usually a key sign that stock prices are extremely vulnerable to just that—going down. And not just slightly, but significantly. Think 20%, 25% or more.

When everyone believes that something can’t happen, then nobody is prepared for that “thing” to happen. This means that if it starts to happen, then a massive rush, or cascade, is likely to develop. And this will accelerate the downside as everyone rushes for the exists only to learn that it’s a tiny 0ne-person-at-a-time door.

Could markets go up some more? Sure. But anyone who can’t appreciate the extreme fragility and the huge risk of downside is simply ignoring the lessons of history and will, with 100% certainty, be burned…..badly.

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