An Extended Rally! Time For An S&P Pullback

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 |  Includes: DIA, QQQ, SPY
by: Sydney Foresythe

Recent Market activity has brought on the realization that the market has overextended its recent rally. Current market conditions lack a catalyst in either direction for the immediate future, therefore investors need to weigh the probabilities of a decided bearish pull back or continued rally in the $SPY. Below are arguments for and against a significant 5-10% pull back in current indexes: SPY, DIA, and QQQ.

Pullback

The Fed signaled a need to revise the longevity of its asset purchase program in its latest FOMC meeting, citing inflation, asset bubbles and possible complications to withdrawing stimulus as material risks of ongoing easing. Gold, crude oil and stock futures are down on the news, while the VIX, a measure of market volatility, is up 20%. The market has rallied despite a lack of indication that the economy is improving materially, with 4th quarter GDP down 0.1% and the unemployment rate holding at 7.9%. While corporate profitability has risen, it has been more a result of cost cutting programs than revenue growth, which strengthens the notion that the market has improved faster than the overall economy, which is growing at a steadier pace.

With the S&P 500 near an all time high, there seems to be no real catalyst driving traders to buy in further, especially as the primary catalyst, QE 3, and Bernanke's recent promise to continue to buy $85 billion of securities a month until employment and the overall economy improves come into doubt. And while equity inflows started off the year positively, recent data shows an net outflow in February as investors started to lock in profits and get more defensive in anticipation of a pullback that it this point seems inevitable. Market sentiment is becoming increasingly negative and more investors are taking the short side of the trade. Hedge fund manager David Einhorn reduced his long positions and increased his short positions. His reason, an advancing market without the presence of an advancing economy to support current valuations. The truth of the matter is, we are not yet out of the wood works. The European situation has improved and is relatively stable but downside risks remain and improvements in the European economy have yet to materialize, with recent economic gauges coming in less than expected. The U.S economy is stronger and optimism is up, but the market has gotten ahead of its self. While there is room for growth, especially as 2013 rolls forward, a pull back in equities to a level that makes valuations more in line with current business and economic conditions is inevitable and near. This market leaves no room for material gains on the long side and investors are paying a lofty price for earnings. A pull back of 5 - 10% in the near term is a more probable occurrence than a 5 - 10% near term rise, which makes taking the short side a better bet especially as global economic readings are coming in less than expected and will compound to trigger sell offs in equities.

Continued Rally

While recent developments from the Fed signaled a need to revise its asset purchase program, the need for continuous asset purchases was never questioned. The underlying factors causing the Fed to continue its asset purchase program is the pace at which the economy is recovering. Economic growth is being threatened by increasing interest rates, therefore as long as 10 year treasuries continue to increase there will be a growing threat to the recovery that was spurred by Bernanke's aggressive monetary policy. An increase in household and business debt costs as a result of increasing rates could serve to derail an already sluggish economic recovery, therefore as 10 year treasuries creep over 2% in the short to medium term there will be added pressure on the Fed to keep policies intact in order to keep rates relatively low and protect this slow recovery from derailing.

While increasing rates threaten the Bernanke "recovery" thus forcing the Fed to leave its asset purchase program as is, the market is also supported in large part by higher than expected corporate earnings; recent earnings reports show that 65% of the 433 companies in the S&P 500 have reported better than estimate revenue. Furthermore, the stock market valuation is still not overbought with a price to earnings ratio just less than 14 which is well below an historic overbought valuation of 16.

The markets show signs of normal fatigue that will not amount to more than a 2-3% correction from its current levels. Having rallied 6% this year and already pulled back 1%, short term fatigue and some profit taking may occur, but longer term investors can rest assured that the breadth of this rally is still intact. The impressive earnings and Bernanke's need to bolster the economic recovery will serve as support for this market and protect it from an excessive or elongated correction.

Disclosure: I have no positions in any stocks mentioned; however we may decide to enter one within 72 hours of this article's publication. 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.