Why You Shouldn't Be Buying Stocks

Includes: DIA, QQQ, SPY
by: Colin Lokey

With the S&P 500 at its highest level since the summer of 2008, investors previously sidelined by reoccurring fears of a double dip recession and nagging worries about a disorderly Greek default may now be tempted to hold their noses and dive into the market where, presumably, they will be swept along to the land of outsized profits by the Dow 13,000 wave. To the casual observer, it is easy to think that the economic recovery is back on track and Europe has finally put its problems behind it. There is some merit to this point of view.

For starters, last month's non farm payroll report showed the economy added 243,000 jobs in January, enough to push the unemployment rate down to 8.3%, and 93,000 more than economists were expecting. The gain was largely the result of a substantial uptick in service sector jobs--this is key, as many analysts believe that manufacturing alone cannot fuel the economic recovery. The brighter employment picture seems to be making Americans feel better about the economy as consumer sentiment surged to its highest level in a year in February. Additionally, manufacturing activity as measured by the ISM, hit its highest level in half a year last month. Add to all of this the fact that, for the time being at least, a disorderly Greek default has been averted and the ECB's Long Term Refinancing Operations seem to have succeeded in stabilizing the market for Italian and Spanish sovereign debt, and you have made a decent bull case for the market going forward.

Having said this, it is worth noting that often the best time to sell is when everyone else is buying. Now may be that time. The bear case has several components, the first is the geopolitical component.

Currently, there are two significant political problems that, when taken together, have introduced a considerable amount of uncertainty into the market. First, Iran has effectively created a floor under crude prices by cutting-off oil exports to Britain and France and by continually ratcheting-up its rhetoric regarding the closure of the Strait of Hormuz through which around 30% of the world's seaborne oil travels. The decision to cut exports is a preemptive move designed to punish France and Britain for their participation in an embargo of Iranian oil set to begin on July 1st--the embargo is an attempt by European nations to punish Iran for its rogue nuclear program. While the disruptions to the oil market are themselves disconcerting, the real concern is that Iran will conduct a preemptive strike on Israel to prevent Tel Aviv from bombing its nuclear sites.

The second political problem investors should keep their eyes on is the civil war currently raging in Syria. While its direct implications for stocks are few, it could certainly introduce more uncertainty into markets if the situation worsens, necessitating intervention by NATO or U.S. forces to put an end to the violence.

The second component of the bear case for stocks is the economic component. While the data has been reasonably positive this year, the fact that consumer spending has virtually flat-lined is cause for concern. Consumer spending accounts for around 70% of U.S. economic activity. After gaining some momentum midway through 2011, spending ground to a standstill during the last three months of the year even as consumer credit expanded--accounting for inflation, spending actually fell .1% in December. Rising oil prices pose a real threat to spending going forward as consumers are less likely to spend when they perceive that gas prices will continue to rise for the foreseeable future.

The third, and perhaps the most critical component of the bear case for stocks concerns the European debt crisis. Put simply: nothing is fixed. The second bailout awarded to Greece is little more than a quick fix to avoid a catastrophic March 20 default. The country will default sooner or later and delaying the inevitable is likely to make the event that much more painful when it actually occurs. Another concern is that the ECB has no current plans to implement a third round of LTROs after next week's second offering. Although difficult to prove conclusively, it is widely believed that the ECB's three year, low interest loans to eurozone banks are largely responsible for preventing a disastrous spike in Italy and Spain's borrowing costs which, had it occurred, could have caused the two countries to go the way of Greece. In the absence of further stimulus, many wonder if borrowing costs will start to rise once again, an event which could plunge the eurozone right back into crisis mode.

The fourth and final component of the bear case is the technical component. On a technical basis, the market looks oversold. The Williams R% indicator reads -11.42 for the Dow, -9.64 for the S&P 500, and -8.32 for the Nasdaq. Readings from -20 to 0 signal overbought conditions. Similarly, the slow stochastic oscillator registers 87.21 for the Dow, 86.05 for the S&P, and 84.67 for the Nasdaq--readings above 80 generally mean the market is overbought. If you don't like technical indicators, you might want to look at it from a common sensical, 'what goes up must come down' perspective. Consider this: five of ten S&P sectors are up by 10% or more already this year. Specifically, materials, industrials, consumer discretionary, financials, and information technology are up 12%, 10%, 10%, 13%, and 15% respectively. Only two of ten sectors are down this year and one of those is off by only .66% (telecom).

Considering the economy is just now limping out of a fairly deep recession and taking into account the extremely volatile nature of the debt situation in Europe and the political situation in the Middle East, it seems this market has come a bit too far too fast in 2012. Now is the time to buy puts on the SPY.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.