What Could Cause a Correction?

To nobody’s surprise, stocks melted up again last week. In the holiday shortened week, the S&P500 inched up almost 1.3%. The Santa Claus rally arrived on time as everyone expected. But since volumes were abysmally low, this increase is not resting on a solid foundation. Volatility dipped somewhat, but only back down to the lower extremes we’ve already seen over the last year. In other words, volatility didn’t fall much more, because there wasn’t much room left for it to fall.

Over bullish doesn’t even begin to describe the extremes at which equities are priced today. According to Investors Intelligence, bearish sentiment has now dropped further (about 14%) to lows last seen decades ago. This suggests that almost everyone who wants to own stocks (and has the capital to actually buy stocks) already owns stocks. Increasingly, it will be more difficult to find new buyers who are willing to put new money to work into stocks at the already record high prices. So it will become increasingly more difficult to continue pushing prices higher.

In macro news, the US economy is still limping along, without reaching escape velocity. Personal income rose a bit, but far lower than expected. But personal spending jumped, as expected. How did this happen? Simple. Consumers either drained their savings (already at very low levels) or took on more debt to fund their purchases. Clearly, neither one of these coping mechanisms is sustainable. Consumer sentiment missed. Durable goods orders beat expectations, as did new home sales. And initial jobless claims beat just slightly. On the unemployment front, next week over 1 million people will lose their extended unemployment benefits; this figure will rise to almost 2 million by the summer of 2014. So not only will all these people lose their ability to buy goods (which will hurt the economy), chances are they will drop out of the workforce (which, perversely, will make the US unemployment figures look better, when in fact it’s getting worse).

Since stock prices are at record highs (with volatility near record lows) while the Main Street economy has yet to properly recover, what exactly can we point to as being a likely ‘trigger’ for a correction in the US stock market? Such a trigger would be important to track because if we wish to stay heavily invested AND be able to escape—at the last minute—any severe correction, when and if it were to take place.

The answer is that there is NO particular trigger we can watch out for. Because the stock market is so ripe for a correction, any number of so-called triggers could spark a significant sell off. So it’s the over-valued state of the market itself that would be the cause of the sell-off. Any trigger, would simply be the excuse that investors and traders would use to run for the exits.

So this brings us to the final point about being on alert to triggers to avoid big losses. If there is no single trigger we can look out for, any investor who believes he can quickly run out the door before the stock market crumbles is deceiving himself. Inevitably, investors will miss the ‘trigger’ and will get caught in the down draft. Some will get hurt more than others, but history shows that everyone who stays in the stock market will get hurt to one degree or another.

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