The market has had a great run to start 2013. Indexes are up approximately 6% since the first of the year. However, the market is starting to feel "toppy" and investors should not be surprised if we give up some or most of the gain at some point in the coming months. Here are five big concerns I believe the market has to overcome, but probably won't, to move significantly higher.
The Beleaguered Consumer -
The expiration of the Payroll Tax Holiday will take $100B to $120B out of the economy and consumer spending. Given the economy posted negative GDP growth in the fourth quarter even with higher business and consumer spending, it will be very interesting to see what impacts this will have on GDP growth going forward. In addition, gas prices posted their highest prices on record in January. This is another significant headwind to the economy. I would avoid retail and restaurant stocks here as these negatives should show in reduced consumer spending in the first quarter.
Profits under pressure -
One of the main reasons the market has moved up in 2013 is earnings reports have come in better than expected. As of this weekend, 70% of companies in the S&P 500 had beat consensus earnings estimates and 67% had beat revenue estimates. Earnings growth for the quarter Y/Y stood at a 4% increase which was better than the 1% to 2% expected before earnings reports started to be submitted. However, earnings growth for this quarter was expected to be in the high single digits Y/Y just a few months ago so a lot of the "earnings beat" is being accomplished by setting the bar very low. In addition, if companies can only produce 4% earnings growth with record low financing costs and historically high profit margins it is hard to see how they accelerate earnings growth going forward.
"Beggar Thy Neighbor" policies are on the uptick -
The Bank of Japan recently joined the Federal Reserve in QE efforts to push their currency down and forced liquidity into riskier assets. The yen is down some 14% and the Nikkei stock index is up some 20% since this began in November. This is a key reason I have a core position in WisdomTree Japan Hedged Equity (NYSEARCA:DXJ) which provides exposure to the Japanese equity market while protecting from a declining yen. France's president Hollande got into this game today by reiterating that the euro is too high and it needs to decline. I would look for the European Central Bank to join the QE game after German elections in the summer. It is the key reason I have a long term short on the euro through the CurrencyShares Euro Trust (NYSEARCA:FXE). This set of central bank policies should also trigger stagflation in the near future and add further pressure to companies' profit margins although it should be good for commodities and commodity stocks.
"Dumb Money" is getting in the market/"Smart Money" is getting out of the money -
Retail investors who withdrew almost $400B from stock funds since the bottom of the market in March 2009 are starting to return to the market since the beginning of the year. At the same time, company insiders are selling shares at an aggressive and accelerating pace. The latest Vickers Report shows insider selling over 9 shares for every share they purchase. This is a marked increase in the insider sell/buy ratio.
Job growth continues to be disappointing -
We have now added a net 650,000 jobs over the last four years, less than 1/20th the increase in the food stamp population which is still growing three years after the recession ended in March 2010. Yes, job growth is showing growth in housing construction and oil & gas but it would take over five years of job growth at the January pace before we would get back to the jobs/population ratio of 2007. It is hard to see robust increases in consumer spending and GDP growth until the economy can add the 300,000 to 500,000 jobs monthly that would normally occur at this point in business cycle coming off a deep contraction.
Given this outlook, I have taken some profits recently. My new long positions consist mainly of long term slightly out of the money calls or bull call spreads as volatility has made option premiums very cheap. This allows me to participate on the upside but provides protection on the downside should we get the correction I expect in the new few months. Happy Hunting.
Disclosure: I am long DXJ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Also short FXE