The year 2010 ended with a bang with the S&P 500 and most world indexes closing at their highs.
December’s powerful rally, however, elevated a variety of contrarian indicators to extreme levels that suggest being cautious in the short term.
The market is displaying overbought technical indicators, record bullish sentiment and highly speculative put-call ratios. Last time we observed these indicators at these levels (January 2010 and April 2010), an important correction occurred in the markets.
When people are too bullish and buying at the highs, they act as “fuel” for a sharp downturn when some negative macro event occurs or earnings disappoint. People buying at the highs tend to run for the exits very quickly when things don’t go as expected.
To buy with little risk, you must buy when there is fear and despair that drives stock prices to bargain levels.
I see that this possible correction could occur during the last days of January. At month’s end, we are entering earnings season and the market tends to remain strong as the most important results are revealed and then sells off. The main results for the S&P 500 will be delivered by Jan. 21. This would be a similar trading pattern of what we saw in January 2010 where the market was at new 52-week highs in earnings season with similar bearish contrarian indicators.
However, if this correction occurs it will be a great chance to buy because 2011 should be a great year for stocks.
Here are three main reasons that are a catalyst to buy:
High Fiscal Deficits = Sustained Money Printing
After Democrats and Republicans failed to take measures for significant budget cuts but agreed to maintain President George W. Bush’s tax cuts for two more years, the fiscal deficit for 2011 and 2012 is estimated to reach approximately $2 trillion, or 14 percent of GDP.
Financing this mammoth debt in the bond market will be tough for the U.S. government and it will require constant help from the Fed. This institution is already the largest holder of U.S. Treasurys in the world.
With its QE2 program, it will continue to “finance” part of the deficit by monetizing debt until June 30. The growing fiscal deficit and high employment will force the Fed to maintain the stimulus for a longer time so I wouldn’t be surprised to see QE3 and QE4. The constant liquidity pumping by the Fed will continue to produce a falling dollar, higher interest rates and high returns on “non-printable assets” such as stocks, precious metals and commodities.
Retail Investors are Pulling Money out of Equity Funds
Since May 2010, retail investors have been pulling money out of stocks and pouring it into bond funds. They have observed the market rocket higher without them even though Ben Bernanke has explicitly said that he wants to create a “wealth effect” with his nonstop monetary stimulus.
With a devaluing dollar and rising interest rates that cause bond prices to fall, retail investors will flock back to the stock market and power the next move higher.
Third Year of Presidential Cycle = Big Gains
Statistics show that the third year of a presidential term is the most positive for stocks. Studies for this cycle show that average gains for the S&P 500 in the third year a term average more than 16 percent. If this pattern remains valid, there is more room to the upside.
In conclusion, look for corrections and dips as opportunities to buy.
One caveat though. Rising commodity prices (oil is hitting $92 today) will start to erode margins of companies that are resource intensive.
Focus your investments on stocks related to technology and low commodity costs or companies that have powerful brands and market niches that will be able to raise prices as their costs go up as their demand is more inelastic.
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