Another Flashing Red Light: Investments in Stocks by Households and Nonprofits Reach Record High

key stock indicesThe general consensus among stock advisors is that the key stock indices will continue to go higher. Each day, I hear about another “bear” throwing in the towel and turning bullish on key stock indices.

“Don’t fight the fed or the tape; just buy stocks, and you’ll do fine” has become the norm again. Sadly, this worries me a lot because the fundamentals that drive the key stock indices higher are becoming weaker with each passing day.

As an example, for the third quarter, the corporate earnings growth rate for the S&P 500 companies was only 2.9%. To some, this might sound great, but look at these three facts: 1) corporate earnings were up 2.9% in the third quarter, but the stock market is up about 13% from the beginning of the third quarter; 2) corporate earnings growth so far in 2013 is running at its slowest pace since 2009; and 3) only 52% of the S&P 500 companies were able to beat revenue estimates for the third quarter. (Source: FactSet, December 6, 2013.) This suggests corporate earnings aren’t really coming from companies selling more, but rather from stock buyback programs and cost-cutting.

Troubles for corporate earnings don’t just end there. Corporate earnings are expected to be weaker in the fourth quarter. So far, of the 103 companies in the S&P 500 that have issued corporate earnings guidance, 89% of them have issued negative guidance!

And aside from corporate earnings, there is another problem brewing for key stock indices…

The chart below shows the dollar amount of stocks owned by households and nonprofit organizations. At the end of the third quarter, this number reached its all-time high!

Corporate Equities, Household and Nonprofit Organisations

What does this mean?

At the core, we see people running to key stock indices just at the point when the fundamentals are getting weaker. History has clearly shown that when the great majority of investors are bullish on key stock indices, when people are buying stocks via the “herd mentality,” that’s when key stock indices usually go the opposite direction and move downward.

Yes, I know I’m the last “bear” standing. And my skepticism towards key stock indices continues to grow as they post new record highs. I was also one of the rare bears who called the October 2007 peak in stock prices and who screamed, “Get out of real estate!” in 2006, when the great majority of economists were against me. Time will be the judge if I’m right this time about the stock market being severely overbought. But I wouldn’t bet against proven historical indicators that say this stock market is out of control.

Michael’s Personal Notes:

Detroit, the “Motor City,” has been approved for bankruptcy. In making the ruling, Judge Steven W. Rhodes, who sits in the United States Bankruptcy Court for the Eastern District of Michigan, said, “This once proud and prosperous city can’t pay its debts.” He added, “It’s insolvent. It’s eligible for bankruptcy. But it also has an opportunity for a fresh start.” (Source: “Detroit Ruling on Bankruptcy Lifts Pension Protections,” New York Times, December 3, 2013.)

In his ruling, the judge also made it very clear that the pensions of city employees might be at stake. He said, “Pension benefits are a contractual right and are not entitled to any heightened protection in a municipal bankruptcy.” (Source: Ibid.)

Looking at what happened to Detroit, I question if we are going to see a spree of municipal bankruptcies in the U.S. economy.

You see, Detroit was a prime example of a city registering budget deficit after budget deficit, year after year. It borrowed to pay for its expenses. It came to a point where it had to tell its municipal bonds holders, “Sorry, we can’t pay you,” and its pensioners, “Sorry, your pensions are non-existent.”

After the housing bubble burst in 2007, cities across the U.S. economy started to register budget deficits as they continued to spend at the same pace despite the decline in property tax revenue.

As it stands, across the U.S. economy, there are a significant number of cities that are struggling to control their budget deficits. Mind you, it’s not just smaller counties that are struggling with this problem. Major cities in the U.S. economy, like Chicago, Los Angeles, and Philadelphia, are stuck with budget deficits and pension deficit issues, as well.

At the very core, the ruling that let Detroit enter into bankruptcy has given cities who are struggling with budget deficits, pension deficits, and massive debt loads an easy way out. They can simply follow in Detroit’s footsteps.

I am very worried about this situation, having written about it many times in these pages before. If we do see an influx of cities filing for bankruptcies due to massive budget deficits, there will be a pension crisis in America and a faster-rising national debt, as the U.S. government gives in to the voter pressure of bailing out cities, municipalities, and counties.