August 25, 2010

Bull Market Myths of 2010 Exposed

The simple truth is that the market was ripe for a major correction.

Analysts always find reasons why stocks should be going up. "But their track record shouldn't give anyone confidence" states a recent Associated Press article.

New research from the consulting firm McKinsey & Co. found analysts tend to be overoptimistic, slow to revise their forecasts and prone to making inaccurate predictions."

Regardless, the financial media distributes analyst predications and estimates often based on flawed assumptions. In this article, we'll address two myths the analyst community likes to refer to:

Myth #1: Stocks are Cheap

Even though the economy is in the worst shape since the Great Depression, economists at large believe that stocks are cheap. In fact, with the S&P trading above 1,200, analysts claim that stocks are the cheapest since 1990 (Bloomberg, April 26, 2010).

Quite to the contrary, on April 16, in no uncertain terms, the ETF Profit Strategy Newsletter stated: "at current earnings, prices and dividend yields, stocks are not cheap. The message conveyed by the composite bullishness is unmistakably bearish. The pieces are in place for a major decline."

If stocks were cheap at S&P 1,200, they must be dirt-cheap at S&P 1,100. Cheap based on what assumption though?

Based on analysts' projections, earnings for the S&P 500 are to reach an all-time high in 2011, surpassing even the 2006 peak. Since earnings make up half of the price/earnings (P/E) ratio, stocks appear cheap based on record projected earnings. The key word is "projected."

Looking at data from the last 25 years, research from the consulting firm McKinsey & Co. found analysts have estimated annual earnings growth to be about 10-12 percent for the S&P. Actual growth has only been about 6%. Keep in mind that the past 25 years housed the biggest bull market in American history.

Myth #2: Cash on the Sidelines Will Drive Stocks Higher

Cash on the sideline is viewed as bullish because, theoretically, it can be used to buy stocks and drive up prices. Some distinguish between corporate cash and retail cash on the sidelines.

Many forget that for every dollar in cash, there is a debt that has to be repaid. According to the Federal Reserve, nonfinancial firms' debt totals $7.2 trillion, the highest level ever.

As far as retail investors go, the current debt-income ratio is at 126 percent. The pre-bubble average was around 70 percent. To get back to the pre-bubble norm, about $6 trillion worth of debt would have to be eliminated.

Retail money in money-market funds is currently around the same level as it was in 2006-2007. Is that bullish?

Unlike Wall Street and the financial media, the ETF Profit Strategy Newsletter takes an out-of-the-box approach to market analysis, which tends to be contrary to both popular analyst opinion and thus more reliable.

More Fuel for a Bigger Decline

A French proverb states that a fault denied is committed twice. Denial, as blissful as it is for the time being, does not serve as protection against the inevitable.

A perfect example of denial is the May 6 flash crash. Neither Wall Street, the financial media, nor investors wanted to see the danger of such a meltdown beforehand. After it happened, they were in denial about the cause.

The simple truth is that the market was ripe for a major correction.

A few weeks before the lash crash, the ETF Profit Strategy Newsletter noted the extremely low CBEO Equity Put/Call Ratio and warned: "It seems that only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling, results in more selling. This negative feedback loop usually results in rapidly falling prices."

As it turns out, there was no clumsy-fingered trader at fault for the decline that reduced the Dow by more than 1,000 points in one day. If it had been a simple error, stocks wouldn't have fallen to new lows after the flash crash. If it had been a simple error, the S&P and Nasdaq Composite wouldn't still be trading below the flash crash close.

Investors who are in blissful denial, have a number of things they don't have to worry about:

Don't worry about bank failures: The FDIC closed down eight banks last week, bringing this year's total to 118.

The alleged bulwark protecting American's savings itself is close to going broke. At the end of the fourth quarter for 2009, the deposit insurance fund was already $20.9 billion in the hole.

Don't worry about foreclosures and falling real estate: According to RealtyTrac, more than 1 million American households are likely to lose their home to foreclosure this year.

How can the economy recover when the foundation of any recovery (rising real estate prices) keeps rotting away?

The list goes on: Don't worry about bankrupt states; don't worry about deflation; don't worry about technical weakness; don't worry about overvaluation; don't worry about deadly bearish sell signals, etc.

In late April, the ETF Profit Strategy Newsletter warned of an impending decline. The initial stage of the decline was met by a counter-trend rally.

The next stage of the decline, likely in progress right now, should aggressively move towards the target range published in the September issue of the ETF Profit Strategy Newsletter.

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