The market has been on a tear after the debt ceiling resolution and a surprise no Fed taper in September. The Dow Jones Industrial Average made a new all-time high last week at 16,174. Sentiment and optimism is starting to come back into the market after a good employment number of 203,000 jobs created and the unemployment rate falling to 7%. I am starting to hear people calling for Dow 20,000. Optimism and bullish sentiment is obviously needed in order for the market to rally.
However, there is a fine line between too much optimism and greed. Greed is good up to a certain point, but too much greed in the market is never good. It is especially scary when the market is at an all-time high. Regardless, the bulls have been right since the market bottomed in March of 2009. The bears are nowhere in sight these days. Can they make a comeback?
Let's analyze both sides of the argument.
Margin Debt: Margin is one of many indicators that investors must consider before deciding to commit capital. History is littered with examples and lessons we can learn from. Below is a chart of margin debt going back to 1966 and its correlation with market peaks. As you can see, the current margin debt is very high indeed. Is it different this time?
Click to enlarge images.
QE Rally: If the economy is so strong and can stand on its own two feet, then why is the Fed so scared to stop or even taper QE? The bears argue that this rally is a house of cards that will soon collapse because the fundamentals are built on sand. Since when does bad news equal good news and good news equal bad news? Without a doubt, the chart below shows the strong correlation between QE and the stock market rally.
Earnings Illusion: Carl Icahn came out in November warning the markets that companies earnings are a mirage and that they are all tied up to interest rates. Icahn does have a point; allow me to explain.
The purpose of the Fed running its QE program of $85 billion/month is to lower interest rates in order to stimulate growth in the economy. By lowering interest rates, the Fed hopes that it will encourage companies to borrow, spend, and invest that capital back into the economy. Low interest rates also lowers interest expense on companies, which helps the bottom line of their earnings. Unfortunately, revenue growth has been flat, if not slightly increased at best, during the past year.
Therefore, to say economic conditions have improved dramatically is simply not true. The bears argue that organic growth is not there and that stocks rally on share buybacks and artificially low interest rates. Going back to interest rates, the 10-year note bottomed in July 2012 at 1.4% and currently sits at 2.82%. Since then, we saw the market rally and launch to the skies -- and it never looked back. If those same low interest rates that help companies with their bottom line earnings are now up, the bears argue that they will have an opposite effect on the bottom-line earnings of companies. Thus, the bears believe that earnings will disappoint this time.
Below is a chart of the 10-year note. We can clearly see what Icahn is talking about.
Shrinking Deficit: Remember the good times in the 1980s and 1990s? One of the trademarks of a boom in economic prosperity is shrinking deficit.
Below is a chart of the U.S. federal government spending and tax receipts as a percentage of GDP.
Energy Independence: Have any of you been to or seen pictures of Dubai or Abu Dhabi? It is simply breathtaking and my words do not do it justice. What do they have in terms of tourism that is attractive, other than a desert of sand to begin with? You see, just like Las Vegas, if you build it they will come. What is behind all this prosperity? Oil exports.
As we slowly move away from our addiction to fossil fuels and move toward more sustainable green energy, the U.S. has been importing less and less crude oil.
At the same time, the U.S. has been ramping up oil production to satisfy demand.
What does this ultimately mean in the grand scheme of things? Well, due to the U.S. oil and gas boom along with the implementation of green energy (think solar, wind, electric cars, etc.), it is estimated that by 2017 the U.S. will become energy-independent and will start exporting crude oil and natural gas. Has anyone ever thought what the U.S. will be like when that happens? Never in the history of the world has the U.S. been energy-independent.
Low Commodity Prices: Commodities have been a loser so far in 2013. Just ask some of the devoted gold and silver bulls out there. As the chart below shows, commodities peaked in May 2011 and have been on a steady decline ever since.
How do low commodity prices impact the economy?
- It puts more money in people's pockets as they spend less on everyday necessities such as food. Therefore, people will have more money to spend on other goods.
- Low commodity prices impact and trickle down the chain of companies. Let's take for example corn prices, which have declined into the low-400 cents/bushel. Corn is an essential part of animal feed, so lower corn prices translates into lower chicken prices and better profit margins for companies such Tyson (NYSE:TSN), which is in the business of selling poultry. Lower chicken prices also mean that restaurants such as Buffalo Wild Wings (NASDAQ:BWLD) will have lower costs in purchasing their chickens, which also boosts profit margins. No wonder stock prices of these two companies have gone to the moon.
Construction Boom: Currently, steel prices are very low. With dirt-cheap steel prices, construction is starting to pick up as prices have become too attractive to ignore any longer. The bulls argue that this will lead to a construction boom, which in turn will create jobs and further improve the economy.
Considering the strong momentum, I do not recommend shorting this market. In addition, there is more and more pressure on hedge funds that have underperformed this year to buy and chase this market. However, I also caution those who are long the market to keep in the back of their mind the risks and arguments posed by the bears. Therefore, I highly recommend protecting your downside risk by buying puts, putting in stop-losses, etc.
To put it simply: Either you are in or you are out, but do not short. I have presented both sides of the argument, the bulls and the bears. What are your thoughts and calls regarding the market and economy as we move forward into 2014?
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.