Tuesday marked another decent rally on low volume. At the risk of repeating myself, I feel we are on the last legs of a remarkable market rally that has been fueled at least in part by the huge amount of liquidity supplied by the Federal Reserve. We have seen this movie before, and we know how it ends. The excess reserves pumped into to the economy by the Fed to ward off any impacts from Y2K was a key factor in the huge internet run up that led to the tech bust of 2000. In response to the recession caused by that event, the Federal Reserve again loosened the monetary reins for too long and became a primary enabler of the housing bubble. That bubble burst and we got TARP, QE1, QE2 and a variety of other Federal Reserve programs. As a result, equities, commodities and every other risk asset have seen huge price appreciation. What happens when that support starts to be withdrawn with the end of QE2? Whatever it is, it is unlikely to be good and we are pretty much out of bullets at this point.
Hopefully, we will only see a pullback of 15%-20% before the market finds an orderly bottom over the summer. However, if Europe breaks ala Lehman it could be a whole lot worse. Here are ten reasons I think we are near a top:
- S&P (SPY) profit margins are at or near historic highs. Given rising input costs, especially from energy and commodities; these will start to come down and reduce expected earnings. Witness the statements from Kimberley Clark (KMB), Wal-Mart (WMT), McDonalds (MCD), Xerox (XRX),…etc all warning of higher costs over last several weeks.
- The continued rise of gas prices. Gas is at or approaching $4 a gallon in most states. This is eerily like the summer of 2008 and will have negative impacts on consumer sentiment, spending, Obama’s poll numbers, and high priced retailers. See UA’s ten percent plunge yesterday on rising inventory levels.
- Continued and escalating tension in the Middle East. Libya, Syria, Egypt, Bahrain, Yemen, Oman, Tunisia, etc….all have seen dramatic unrest. This will continue to impact oil prices and has the potential to be a Black Swan if it spreads to a major oil producing state like Saudi Arabia.
- IPO Activity is at a four year high, which is generally a good contrarian sign for the market.
- Seasonality as we are entering historically the worst time for the market. Sell in May and Go Away seems like an appropriate rallying cry this year.
- Europe. Austerity measures are negatively impacting growth. Greece and Ireland have received bailouts, but will probably need to restructure their debt eventually. Portugal is waiting its turn and Spain is on the clock. Voters predictably are choosing parties that might reject supporting any further assistance; see Finland. This cauldron has the potential to blow up any day.
- China is taking more and more measures to curb inflation and property speculation. This will eventually have negative impacts to worldwide growth.
- Merger Monday is back as we have seen a large increase in M&A activity this year. Another good contrarian sign.
- The end of fiscal stimulus and state budget challenges will severely curtail job and economic growth as state and local governments enact plans to balance budgets through layoffs and other spending cutbacks.
- Given the approaching end of QE2 as well as the upcoming federal budget battles, the political acrimony that will be unleashed is not likely to be good for overall health of the market environment.
Be careful out there. Keep a good amount of cash ready to deploy at lower levels. Stick with good solid blue chips like Exxon Mobil Corp. (XOM), Microsoft (MSFT), Abbott Laboratories (ABT), Telefonica (TEF) and Intel (INTC), that have reasonable valuations, solid balance sheets, and good dividends. Avoid those high flyers that have a huge run up in this liquidity fueled market rally with very stretched valuations like Salesforce (CRM), Under Armour (UA), OpenTable (OPEN), and Lululemon (LULU).