Why It’s a Dangerous Time to Be Long on Stocks

“Calling the Trend” Column, by George Leong, B. Comm.

This is developing into a dangerous time to be long on stocks or to add to positions. Markets have declined in seven of the last nine sessions to last Wednesday and, in the process, to below some key technical levels. About 85% of U.S. stocks are below the 200-day moving average(MA), versus 92% last week. The growth sectors of technology and small-caps are attracting most of the selling, which is not a surprise given that they have risen the most this year. The chart of the small-cap Russell 2000 shows a bearish double top.

On Thursday, we saw a stronger than expected third-quarter GDP growth of 3.5% — the strongest reading in two years and perhaps the end of the recession. The government stimulus spending helped to drive the economy, but there’ll be concern about whether the economy can continue to expand as the government’s spending is curtailed. GDP growth for the fourth quarter is predicted at 2.4%, followed by 2.5% in the first quarter of 2010, according to the National Association for Business Economics. Yet, other groups predict much slower GDP growth. In my view, growth in the third-quarter GDP was widely expected and discounted into the recent rally. The hesitancy we are seeing in trading after the report is likely due to concerns on how strong the GDP will be in the fourth and first quarters.

We continue to advise caution given the lackluster revenue growth in the third quarter.

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In housing, a weaker than expected new homes report is reminding traders that all is not well. The upcoming expiry of tax credit for first-time owners is resulting in reduced mortgage applications. The government may extend the tax credit into 2010. The Case Shiller Home Price Index rose in August from July, but fell year-over-year. There are signs of improvement in housing, but we are a long way from price increases. Case in point: a weaker than expected new homes report reminded traders that all is not well.

As I have said in the past, until we fix the housing market and jobs, there will continue to be risk.

The VIX is rising, an indication of potential higher volatility. The rally looks somewhat tired and needs a fresh dose of positive news to attract buyers.

There is concern with the lack of revenue growth in the third-quarter earnings, despite earnings that have largely beaten estimates. The earnings quality is in question, as the pop in earnings has largely been driven by deep cost-cutting. Until we see revenues grow, there will be questions about the condition of businesses.

If markets stall, you may consider writing some covered calls on your long positions to generate some premium income. Be careful, as this strategy is vulnerable to rallies in the stock and loss of potential profits should the stock price move above the strike price where you would be forced to sell the stock.

The key in this market is to monitor your positions and take some profits on the big winners. The last thing you want is to see the bid gains disappear. Always take some profits along the way, especially in a rising market.