Don't Fall Asleep!

Includes: DIA, IWM, QQQ, SPY
by: Bret Jensen


After yesterday's rally, the S&P 500 is at all-time highs as we approach the mid-year point.

However, as the volatility index moves to seven-year lows and stock volume is drying up, the market is feeling much too complacent at these levels.

There are also other danger signs for the market as we head into the second half of 2014. Caution is the watch word in the months ahead.

As we approach the mid-year point for 2014, it is appropriate to take a look at road ahead and where we have come so far in equities. The S&P 500 has led the market forward with a return of around 6.5% so far this year, including dividends. The index is currently at an all-time high. A solid performance as we approach the end of the first half of the year. The NASDAQ, DJIA and Russell 2000 have turned in slightly lesser performances. It has definitely paid to be in safe blue chip stocks so far in 2014.

So where do we go from here? My personal opinion is that navigating the market in the months ahead is like driving home from somewhere in the Midwest after a very long barbecue party over at friend's house. There were plenty of ribs, football and of course, beer. A good time was had by all. Other than falling asleep or hitting a hog or a deer on that lonely road there does not seem to be much danger ahead.

The main danger right now in the market is complacency. The volatility index just hit a seven year low and it feels like a lot of investors are starting to fall asleep at the wheel. Over the past 18 months, earnings for the S&P 500 have climbed roughly ten percent while the market has climbed some 40%, including dividends. The simple fact is most of the rally has been fueled by expanding earnings multiples, not earnings growth. In addition, this rally has occurred on lower and lower volume (See Chart).

Click to enlarge

A good portion of that market multiple expansion has been driven by extraordinary liquidity measures put in place by the Federal Reserve. However, the Fed is slowly withdrawing from that largesse and soon will be providing only $35B a month to the credit markets and should be out of any remaining "QE" efforts by the end of the year.

This has not been felt in the market as of yet. Interest rates and yields on ten year treasuries have actually fallen since the first of the year. A good portion is due to the fact that the Federal Reserve has a lot less government debt to buy up in the market as the deficits have fallen significantly over the past 18 months. The pace of that deficit reduction will slow in the months ahead and as the Federal Reserve withdraws completely from QE, interest rates are likely to reach or broach the levels they'd begun the year at.

With recent U.S. inflation data on the "high side," the chances of the Federal Reserve slowing the pace of their "taper" is also remote. All of this would be fine if the U.S. economy was finally breaking out of the tepid ~2% annual GDP growth it has been stuck in since the recession officially ended in June 2009. But alas, this is not to be the case. Lost a bit in the rally after the Fed meeting yesterday was the fact the central bank cut 2014 estimated GDP growth to 2.1%-2.3%, from 2.8%-3% previously. It looks like we will continue to muddle along in what will easily go down as the weakest post war recovery on record.

Given the current administration's recent record of consistently being behind unfolding global events (Syria, Crimea, Ukraine, Iraq, etc. …) and its vapid response to these crises so far, the possibility of a geopolitical event upsetting the market should not be discounted either.

My own portfolio is up nearly 10% as we approach the mid-year. I am following the same course I would take if I was that driver on that Midwestern road after one or two too many beers. I am going to pull off the road, take the keys out of ignition and crawl into the back seat and get some shuteye.

Simply put the market just feels like it is due for a pull back. Based on trailing price earnings ratios, the market is very much in overbought territory right now (See Chart).

Click to enlarge

For me, this means I am in the process of selling most of the defensive high yield plays that served my portfolio so well early in the year as interest rate fell. It also means selling out of the money calls on my growth portfolio that has done well recently. This leaves me with a higher allocation to cash than I typically carry within my portfolio. Hopefully when I wake up - say late summer - I will find a market that has lower entry points beckoning for me to deploy that capital. Stay safe and stay awake is a good motto to navigate the current market in my opinion.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.