Reality Kicking into the Stock Market

As John Maynard Keynes said, “The market can stay irrational longer than you can stay solvent.” His theory remains true in this current economic environment.

Since June of this year, we have seen the S&P 500 and other key stock indices rise significantly.

As I have been saying, bear market rallies can go on for a long time, but irrationality does eventually go out of the markets, and when reality kicks in, it takes all the pride and glory with it. The fact of the matter is that we are currently in a secular bear market, and the bear stock market rally we’ve witnessed since 2009 is slowly shifting gear.

Participation and rising future expectations are the most important ingredients for a stock market rally. At one point in an economy, things may look bad, but if future growth expectations are good, then a stock market rally can be justified.

But in the current stock market rally, the participation is decreasing and the future expectations are awful at the very best.

In the last week of September, while the stock market rally continued, investors pulled $5.1 billion out of the U.S. stock market mutual funds. Similarly, in the first week of October, again as the stock market rally continued, there was a net outflow of $10.6 billion from U.S. stock market mutual funds. (Source: Investment Company Institute, October 10, 2012.) That’s an increase of 106% in outflows in one week!

Individual investors are usually wrong about the stock market. If they are pulling money out, contrarian investing tells us key market indicators should rise. But at the rate money is coming out of the stock market, stocks have to be sold to generate cash to give money back to investors. Selling puts pressure on stock prices to go down.

As for future earnings expectations, as I have written, more companies are providing pessimistic earnings outlooks. If you take the Fed’s money printing out of the picture, companies are struggling in the current economic environment. Many companies used cost cutting as the only way to show rising profits following the Great Recession.

You can add Advance Micro Devices, Inc. (NYSE/AMD) to the list of companies providing negative outlooks. The company expects its third-quarter revenue to fall by 10%, as the global economy is weakening and personal computer sales are in the slumps. (Source: Reuters, October 11, 2012.)

Dear reader, the following traditional indicators continue to flash warning signals with this stock market rally: Dow Theory non-confirmation of the stock market rally, stocks rising on lighter volume, corporate insiders selling stock at a record pace compared to their buying, companies are reporting earnings at the slowest growth rate in three years, and global economic growth is slowing. Watch that stock market rally. (Also see: Fundamentals Behind S&P 500 Rally Very Weak.)

Where the Market Stands; Where it’s Headed:

It’s a big week for the stock market, as I count about 80 large public companies scheduled to announce their third-quarter earnings this week.

According to a company that surveys stock analysts, FactSet, profits for the S&P 500 companies fell 2.6% in the third quarter, breaking a streak of 11 consecutive quarters of increasing profits. How the market reacts to the actual reports released this week will give us a good indication of the life left in the bear market rally.

What He Said:

“The proof the party is over in the U.S. housing market could not be clearer to me. The price action of the new-home builder stocks is telling the true story—these stocks are falling in price daily (and the media is not picking it up). Those that will hurt most when the air is finally let out of the housing market balloon will be those buyers that bought in late 2005. In fact, the latecomers to the U.S. housing market may end up looking like the latecomers to the tech-stock rally that ended so abruptly in 1999.” Michael Lombardi in Profit Confidential, March 1, 2006. Michael started warning about the crisis coming in the U.S. real estate market right at the peak of the boom, now widely believed to be 2005.