Trouble Looming In The Market...

by: Zachary Scheidt

Editor's note: Originally published on July 15, 2014

As a general rule, I am a relatively laid back guy… I don't yell, I don't lose my temper and I avoid sensationalism. I'll always give you my pure, honest take on the markets (without sugarcoating anything), but normally, I try not to get too animated.

Reason for Concern in the Market…

However, today I'm very concerned with the stock market. In fact, I'll go on record as saying that the second half of 2014 could wind up being devastating for most conventional investors. Most "normal" investors have been lulled to sleep by the relative calm of the market. The blue chip indices (namely the S&P 500 and the Dow Jones Industrial Average) have experienced some of the lowest levels of volatility seen in years and years. For weeks and weeks, these indices have routinely hit new highs with very few (and very mild) pullbacks along the way.

Conventional investors think this is great news! As long as stocks keep trading higher, they make money. And with pullbacks being extremely mild, these investors can sleep well at night knowing that their investments are fairly secure.

The naive perspective of most investors today reminds me of an analogy I heard recently. Think about how a farm-raised turkey must feel heading into the holiday season. Each day the farmer shows up with plenty of food and water. The farmer offers protection and comfort to the turkey - allowing the turkey to become lazy and fat. What could possibly be wrong with this picture??

Ultimately, the turkey believes that he is safe and secure, being well fed and taken care of… Right up until a few days before Thanksgiving, when everything changes.

It may be a corny example, but today's conventional investors are just like the holiday turkeys. They have been conditioned to feel safe and secure - while at the same time risks are mounting. Last week we saw some very clear signs of transition in the overall market, signs that I have been warning you about for several weeks now. Hopefully, you have already begun protecting your investment account against the upcoming market storm. If not, I want to convince you today to begin taking measures to ensure that you emerge from the next bear market unscathed.

A Tinderbox Ready to Ignite

Let's use another analogy to discuss what is going on in the market right now. Forestry services have long regarded small natural forest fires as healthy events because they burn off dangerous underbrush, allowing the forest to grow without danger of fire that becomes much more massive and destructive.

If forests go for years without a small fire to burn off the underbrush, the tinder will build and offer too much fuel for when the nest fire ultimately hits the area. With too much underbrush acting as fuel, the fire burns much hotter and expands to the point where it is totally out of control. This damaging fire can cause MUCH more damage than any "light" fire that may have happened naturally.

What is the lesson for forestry services? Don't always extinguish small forest fires because they can be healthy for the long-term growth of the overall forest!

If only the Federal Reserve was as smart as your average forestry service…

Mistakes of the Federal Reserve

Ever since the financial crisis of 2008, the Federal Reserve has been acting like an ignorant forestry service, extinguishing any small fires and allowing underbrush to grow unabated. Whenever the U.S. stock market has pulled back a bit, the Fed has gone on record saying that it will do whatever it takes to support the market. It has kept interest rates at extremely low levels and it has pumped huge amounts of capital into the bond market - which has driven investors into risky assets.

The Fed's actions have essentially pushed stocks to the point where they are now trading at excess valuations. Last week I showed you charts of some of the most important Dow components which are trading well above their average valuations compared to earnings.

Conventional investors are now euphoric! They feel bulletproof because the market simply continues higher. They have essentially become Thanksgiving turkeys - fat, lazy and completely ignorant of what is happening. Even if the "professional" investment advisors tried to convince investors to reduce their risk, the pleas would fall on deaf ears.

But the professional money managers would never actually do that… They have too many incentives to keep plowing their clients' assets into risky stocks. After all, they need the fees and expenses from the conventional investors to pay for their lavish lifestyles. The entire game is rigged towards driving stocks higher with naive investor capital - until things reach a breaking point.

My friends, I believe that breaking point is imminent!

Small Caps are Leading Indicators

There are few leading indicators as reliable as the price action for small-cap stocks. These stocks are often more volatile than their blue-chip counterparts because investors act in a more speculative manner with these stocks. When expectations are high, small-cap stocks are the place to be. After all, you're going to have more growth from these small companies with big prospects.

But when things are turning, investors bail out of small-cap stocks first. This is because smaller companies are more vulnerable to economic setbacks, while large-cap companies have more resources and more stability. Last week, small caps took a major tumble, falling sharply as fear began to set in. Take a look at the price action for the Russell 2000 Small Cap Index (NYSEARCA:IWM) below.

Image: Russell 2000 Small Cap Index (<a href='' title='iShares Russell 2000 ETF'>IWM</a>)

One interesting thing to note is that IWM broke down from the same level that it topped out at in March. Traders refer to this type of action as a "double top" and while chart patterns aren't magic, they do give us some very important information. In this case, it is clear that investors have a ceiling in terms of what they are willing to pay for small-cap stocks. And that ceiling has now been tested and verified.

Last week as IWM began breaking down, I recommended that members of my Pullback Profiteer trading service buy long-term puts on the small cap index. While we paid a bit of a premium for the long-term put contracts, I expect that a major decline in this index will give us massive profits. Already we are seeing a very attractive gain in our position - one that I expect to grow quickly over the next few weeks.

Now that small caps are breaking down, the next step will likely be a significant pullback in the more popular large-cap indices. I can't tell you exactly how far the market averages will fall, but let's keep the forest fire analogy in mind. It has been a long time since markets have been allowed to pull back. So with valuations at stretched levels and investors extremely complacent, we have a perfect environment for an inferno!

Trading legend Paul Tudor Jones has noted that the most dangerous bear markets tend to begin with an increase in inflation along with rising interest rates. Don't look now, but both higher inflation and higher interest rates are in play right now. We've already begun to see wage inflation and some key price indicators tick higher. And the Fed is now openly debating the prospect of allowing interest rates to move higher. Folks, it seems that we have all the elements in place for a massive bear market forest fire - one that can burn you if you're not prepared.

What to Do?

My message to you today? Don't be a turkey!!

Make sure that you are protecting your assets from the coming bear market. Don't listen to the conventional "professional" advisors who want you to stay fully invested and leveraged.

Instead, take some profits off the table. Buy some puts to profit from stocks falling. Hedge some of your stocks by selling call contracts. And resist the urge to sit back and feel "safe."

Contrarian traders know that when the majority of investors are comfortable, it is time to worry. That time is upon us and the choice is now yours. Either put a plan into gear - giving yourself an opportunity to profit from the upcoming market decline, or suffer the same fate as the average "conventional" investor.

I'm done… No more rants, no more pounding the table, no more animation. I wish you every success and tremendous profits as we enter this key transition period.

Disclosure: No positions.