With the Dow Jones hitting new all time highs almost every day, there are a lot of skeptics that don't believe the rally can last much longer, and plenty are calling for a major correction. I believe this rally is a real, long-term rally, but I am very concerned about the short term. There are four very troubling things that are cause for concern about a short-term pullback or correction.
None of these things are so big that the rally cannot overcome them, but they may cause short-term weakness, volatility, and a pause in the broad market rally. I believe in the rally, but I believe there may be a better time than the present to buy.
1) The Dollar
The market has been fueled, for years now, by the easy monetary policies of the Fed. Effectively devaluing the Dollar is great for the performance of equities traded in dollars. Many are calling for an end to a cycle of Dollar weakness, especially now that other countries are starting to work to devalue their own currency. The Cyprus bailout certainly won't be doing anything to decrease the value of the Dollar either.
We don't have any way of knowing precisely what the effect of a currency battle will be, but it is safe to say that the Dollar does not have much room to lose any more value in the near future. As soon as the dollar begins to find a stronger footing, U.S. stocks may begin to lose theirs. In the past, a single day of significant Dollar strength has been enough to beat the major averages down.
2) The Dow Jones
The Dow Jones 30 stocks (DIA) are performing very well, causing the Dow to break into new all time highs. The problem I have is that the S&P 500 (SPY) is not. A few years ago I worked with an investment manager who has worked at various major banks for some time, he always pointed out times where the Dow would lead the other major averages up, only to drop them at the end of the trading day. It actually happened somewhat consistently. This feels like a bigger picture version of that scenario.
The percentage of advancing vs. declining issues is close to 50/50, so it's no surprise that the S&P is not performing as well. It's tough to keep up when you're made up of 500 stocks and people are picking up the good stocks to leave the losers behind. This is not to say that there is some sort of "smart money" intentionally drawing the Dow up to dump their positions at a gain, only that it is important to look at the real root of the rally and what is driving it.
3) Dr. Copper
It's nothing that hasn't been said before, and I do not think that copper needs to rally for the broad market to rally. Nonetheless, copper has not performed as well as you would think, even though it is probably the most utilized metal in the recovery that we are supposedly experiencing. If you believe the rally is real, copper looks pretty cheap right now, you might consider getting long. I personally have to wonder why there aren't many people who seem to be taking that position.
Utilities have long been considered a proxy for bonds. In the past month the utilities sector has outperformed the S&P by nearly one percentage point. The SPDR utilities ETF (XLU) is trading at 18 times earnings (15x forward earnings) and boasts a dividend yield of about 3.75%. It was only a month ago that we saw headlines of record bond outflows, and record flows of capital into equity funds. It seems that there are plenty of investors "moving to equities" but hiding in safe havens like the utilities. It was one of the best performing sectors in the last month.
Again, these are things that can cause very volatile trading and short-term weakness, not things that will cause a 20% decline. If trading is what you are interested in, any of these will give you a great opportunity to trade with more volatility. Volatility happens to be at multi-year lows right now, and could spike even without a major market decline. There are plenty of ETFs that give exposure to volatility, they could be used to hedge against any of these events. With volatility at multi-year lows, it is unlikely the hedge would cost very much if volatility did not spike. My favorite of these ETFs is by iPath (VXX).
I don't think the market has topped here permanently, but I do think there will be better buying opportunities relatively soon. Giving the markets a chance to work out some of these issues will make me much more comfortable to invest for the long term.