4-Year Stock Optimist Turns Negative - 4 Signs Market Is On Thin Ice

Includes: DIA, SPY
by: John Tobey, CFA

Beware Ice signFor four years, since March 9, 2009, I've actively invested in the U.S. stock market and written about the benefits of doing so. Now, however, that has changed. I've just sold (last Thursday, 2/21) all but one holding and gone to cash.

While others also are worrying about the stock market (see excellent article at end of this write-up), my view comes from a unique source: my current strategy of focusing on growth stocks making new highs, an approach I have used since 1964. Because these stocks often lead in a bull market, abnormal action can provide early warning signals, and that's what I believe has happened.

Today's thin ice market

Usually, worrying about a market top occurs when stocks are bubbling, rising rapidly to new highs on big volume with investors fully committed, valuations high and the media presenting ways to get rich. Clearly, that's not today's market and was one reason I thought investor optimism could return in 2013 ("Optimism's Re-Emergence Could Shake Up 2013's Performance"). And it could yet. However, the market now has unstable drivers, and I believe they have it on thin ice.

The forces are two different investor groups. Group #1 (underweighted in stocks) is happily investing steady inflows into the stock market at today's prices, while Group #2 (fully invested) is happily holding stocks with sizeable gains at today's prices. These two conditions don't always cause problems, but the distinction is so pronounced (both in size and in time elapsed) that the risk of one or both groups losing their happiness is reasonably high.

New high analysis reveals four signs of trouble ahead

The first sign is "upward drift." An inordinate number of stocks have been rising, seemingly daily until late last week. More and more stocks have even been making new highs (both 52-week highs and the more difficult all-time highs). Moreover, the pattern is unremarkable and "worry-free." With so many underlying stocks following this pattern, the S&P 500 likewise showed the upward drift (hollow bars are up days).

S&P 500 daily graph
(Click to enlarge)

(Stock chart courtesy of StockCharts.com)

The second sign is "humdrum trading." The effortless upward drift lacks its usual, visible engine, and that's a serious problem. Moves to new highs most often require higher trading volume to push a stock into new high territory. So, why the difference this time? I believe it's those two groups. Group #1 wants in and Group #2 is content to watch its gains increase. Steady inflows + lack of selling = upward drift with unremarkable volume.

The third sign is "new high abnormality." For weeks now, my search for new high, growth stocks that look attractive has turned up nothing. That would be okay, except the number of stocks making new highs keeps growing. For example, I just finished looking at 30 new highs and eliminated all for the same reason - an upwards wandering on lackluster volume. There is now a huge contingent of these unsupported movers, and they are all at risk.

The fourth sign is "overly correlated portfolio moves." Typically, my new high, growth holdings tend to follow individual routes. Instead, they all joined the upward drift.

The bottom line

U.S. stocks' steady uptrend raises concerns because trading volume has not kept pace. This upward drift has allowed stocks to effortlessly reach new highs (an action typically requiring a strong investor push). Moreover, a large complement of stocks is acting in unison.

The cause is likely two investor groups fostering the move:

  • Group #1 - Underweighted investors plowing money into stocks at today's prices
  • Group #2 - Fully invested investors content to watch their holdings and gains rise

This helpful, but non-binding, coexistence could come undone when the stock market drops enough to create uncertainty or worry. Therefore, I have decided to sell and wait for today's abnormal conditions to become normalized again.

Addendum: Another article to read

Just published is Michael Santoli's Did the Promised Market Pullback Just Come, and Go? The always insightful Santoli tackles the stock market's upward drift and past few days' action. He describes well the conflicting opinions among investors currently. Two important points are the following:

It's telling how quickly anxiety levels and demand for protective stock options surged on a drop of a couple of percent, perhaps because things had been so calm for so long. It pays to remember that even widely anticipated, hoped-for pullbacks that can reset expectations and refresh buying interest always come along with scary prospects that they are the start of something nastier. Not all tremors are followed by earthquakes, but you never know in advance which ones will be.

Beneath the surface, it appears the market needs to rebuild momentum and gather up more buying interest if the major indexes are to do anything more than simply tag their all-time highs (less than 1% higher for the Dow, 4% for the S&P 500). This can occur either by chopping around sideways for a while in mutually frustrating fashion or through a quick run to lower prices.

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. Positions held: Cash reserves and one, special situation holding (Cyberonics - CYBX)