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Fundamentally we are in a bull market: Overall, I think, we are in a bull market. Fundamentally, the US economy is not anywhere close to a bubble. It is slowly getting better, average incomes are increasing, and corporate balance sheets are the strongest they've ever been historically.

Household debt service ratio (HSR) is at 10.61 (lowest 10.51 in Q383 and highest 14.08 in Q307) while the household financial obligation ratio (FOR) is at 13.9 (lowest 13.3 in Q480 and highest 17.66 in Q307). These ratios indicate debt levels of households and their ability to service the same. We are close to the lowest levels seen in early 1980s which was the beginning of the great bull market. Historical low levels, as seen currently, depicts that households have significantly delevered and have the ability to take on additional debt that can further fuel the economy. Besides, as of December 2012, my proprietary index has indicated a strong recovery and stood at -1.9%. This is nowhere close to 13.0%, which is the danger zone depicting bubble like characteristics.

Technological innovations will create jobs and increase consumer spending. The shale revolution and increased use of electric and fuel efficient cars will also help in declining fuel prices which will only benefit the economy. Housing is picking up and some very smart investors are betting on a housing boom in the future. If passed, President Obama's immigration policy would also provide a significant boost to the economy as the immigrants would buy houses, start new businesses and spend more freely. So if everything is so rosy, will the market keep going up? Probably not in the short term (3-6 months), as we might see some correction mainly because of six reasons:

1. Market rally: Market has come up way too fast. S&P (NYSEARCA:SPY) has been on a roar. It has gone up approximately 11% in last three months, so a correction wouldn't be unreasonable and probably healthy. About 88% of the stocks are above their 50-day moving average, and we have the right ingredients for a decent pullback.

2. OECD leading indicator: As of December 2012, OECD leading indicator was at 101.04. The peak zone is close to 101.5, at which levels you probably want to book profits and buy some protection. Selling at 101.5 while the indicator is rising has given great results (future annual S&P return less than 0%) 58% of the times, satisfactory results (future annual S&P return less than 7% in a year) 29% of the times and wrong results (future S&P return more than 8% in a year) only 13% of the times, since the data has been tracked (1955). The indicator is rising at pace and approaching peak levels.

3. VIX: VIX (measures S&P options implied volatility aka fear index) was down by 24% in last three months. As of 19 February 2013, VIX was at 12.3, a level below 13 shows complacency in the market:- screaming out loud that options on S&P are cheap as implied volatility is at its low. In its 23 year history, 9.3 is the lowest and 80.9 is the highest for VIX. On 20 February 2013, VIX jumped almost 20% in a day to close at 14.7. This was mainly due to talks and concerns raised about risks of more QE during the FOMC meeting. A number of fed officials said tapering QE may become necessary. The point being VIX can soar on any news from levels below 13. Anything below those levels shows that potential risks are probably not rightly priced.

4. SPY and TLT pattern: Below is a chart comparing SPY (ETF for S&P 500) and TLT (ETF tracking 20+ year US treasuries). The chart depicts the fundamental relationship between the two. Whenever there is an open jaw like structure, where the one goes up too fast and the other goes down too fast, they seem to converge in the future. We see one such structure now.

(click to enlarge)

5. Shiller P/E: The Shiller P/E (S&P 500 divided by the 10-year average of inflation-adjusted S&P earnings) is currently at approximately 22x. This is a long-term based metric of market valuation. Anything above 24x is when investors should get cautious. At bear market lows, the Shiller P/E has typically been about 10x or less and at bull market highs, it has typically exceeded 24x. The Shiller P/E was approximately 25x in June 1901, 32x in September 1929, 22x in February 1937, 24x in January 1966, 44x in December 1999 and 28x in May 2007. All of these were market peaks, resulting in declines as significant as elevated the ratio was. At a long term average P/E of 15.5x and the current TTM S&P reported earnings of 87.96 as of December 2012, S&P-500 should be trading at approximately 1362. It is currently at 1511, about 10% above its long-term average. Valuations are rich and volatility is low, a perfect recipe to produce disappointing results.

6. S&P earnings estimates: Wall Street strategists have high hopes for the U.S. stock market in 2013. However, S&P operating margins peaked at 9.5% (highest in last 13 years) in Q212 and were at 8.9% in Q312. The US corporates are the leanest they've ever been historically. There is not much to squeeze to increase margins. If you ask an economist, he will tell you that the profit margin cycle is one of the most mean-reverting cycles in the economy.

The chart below shows a clear trend of declining growth in operating earnings. Significant increases in earnings during FY10 and FY11 were mostly due to a productivity-driven earnings boom, which resulted in increased margins. That has gradually lost steam as there is only so much companies can squeeze to boost margins. As previously mentioned, the US corporates are the leanest historically and peak margins are now trending downwards. It is important to remember that compounded annual growth rate of earnings of S&P 500 companies from 1900 until current, is approximately 4.71%. This number speaks for itself, as a period of strong growth in earnings cannot be sustained for a long time and has to be followed by a lower or negative growth in earnings. Nonetheless, earning expectations for 2013 are high.

So if margins cannot be increased, the top-line needs to swell to see growth in earnings. However, growth in S&P sales per share is falling. In recent quarters y-o-y sales growth have fallen from the peak of just north of 10% to 1.1% as of Q312 (see chart below). With lower base in FY09 and FY10 due to significantly distressed sales during the Great Recession, we saw momentous sales growth in FY10 and FY11. That's not easy to achieve with the current high revenue base.

So, in a nutshell, we have peak margins which means a boost to the bottom-line can be attained only through sales growth, but the sales growth is declining as the base is already high and the economy is growing at a slow pace. Additionally, analysts have been lowering their forecasts since early October consistently amid rising fears of the fiscal cliff, tax increases, Europe's recession and China's slowdown. Q412 earnings forecast was revised from 9.9% expected increase (in October 2012) to 2.8% expected increase (revised in January 2013) to -1.7% expected increase (revised in February 2013, 87% of the Q412 earnings reported). All that said, many strategists still see the S&P hitting new record highs by the end of 2013 even as profit growth forecasts for the index have fallen sharply. They are expecting a 14.7% increase in operating earnings to USD 111.3 and a 14.5% increase in as reported earnings to USD 100.7. Considering the high revenue base and end of productivity gains, I think, this is an optimistic view which makes S&P vulnerable.

Conclusion: It is probably the right time to buy some protection (S&P puts or VIX calls) to hedge your portfolio. If S&P rallies another 2% - 3% in a month and if the OECD leading indicator reaches 101.5 levels with VIX declining even further, it would not be a bad to increase positions on that cheap protection. However, if I am right and if there is a correction, one should look for opportunities to buy once the market has corrected, as fundamentally we are in a bull market.

Disclosure: Long SPY put spreads and long VIX calls.

Disclaimer: It is very important to read the disclaimer before making any investments based on the above article.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Long SPY puts and long VIX calls

Source: Long-Term Bull Market But Short-Term Correction