by Michael Lombardi
While 2013 will go down as the banner year for the S&P 500 and other key stock indices no one expected, the number of warning signs about this overpriced and overbought stock market has only increased. And my readers need to know about them…
Trading volume, which is the number of shares traded, fell in 2013. The chart below (bottom portion of the chart) shows trading volume on the S&P 500 was the lowest in 2013 since 2006 (circled area). Trading volume on the S&P 500 in 2013 was 573.4 billion-14.4% lower compared to 2012, when it was 670.1 billion. How does a stock market rise when there is less demand for stocks?
Chart courtesy of www.StockCharts.com
Next, the yield on the bellwether 10-year U.S. Treasury surpassed three percent last week- its highest level since July 26, 2011. The yield on the 10-year U.S. Treasury is now higher than the yield on the 10-year government bonds issued by Canada, Germany, the Netherlands, Switzerland, Japan, and even France!
Why is this so important? The rising yield for the 10-year U.S. Treasury makes stocks less attractive (why buy the Dow Jones Industrial Average with a dividend yield of only 2.09% when investors can get a guaranteed government yield of 3.02%) and housing more vulnerable (the standard 30-year U.S. mortgage is closing in on an interest rate of five percent- the last time it hit that rate was back in January of 2010).
But unlike July of 2011, when the 10-year U.S. Treasury was last yielding three percent, interest rates are not expected to decline, but to continue rising. The Federal Reserve has started pulling back on its money printing and the consensus is that the Fed will continue to announce a slight increase in tapering on each of its scheduled 2014 Federal Open Market Committee meetings. The era of ultra-low interest rates may finally be behind us. If there is one single factor the stock market and the housing market don't like, it's higher interest rates.
Moving to corporate earnings… S&P 500 companies are showing better corporate earnings by using what I call "financial engineering." They reduced the number of shares they have outstanding via stock buyback programs. This process results in a rise in per-share earnings in spite of there being no change in profits as a company's profit is simply divided by a lower amount of outstanding shares. In the third quarter of 2013, share buybacks by S&P 500 companies rose by 32% year-over-year. They purchased $123.9 billion worth of their own shares in the third quarter! (Source: FactSet, December 20, 2013.)
And optimism towards the key stock indices is soaring high - reaching its highest level since 2007! If there is one thing I have learned over the years of investing in the stock market, it's that when everyone leans one way, the market usually goes the other way. Don't just take my word; turn on the TV and you will probably hear someone say the Dow is going to hit 20,000 in no time.
Finally, American consumers don't have endless pockets of money or credit to continue making purchases. As interest rates rise in an environment where there has been no real disposable income growth in five years, consumers will pull back on spending, putting pressure on the corporate earnings of the S&P 500 companies. Just last Friday we learned the four major U.S. automakers fell short of their December sales expectations.
According to General Motors Company (NYSE:GM), the U.S. auto industry will post December auto sales at an annualized pace of 15.6 million units, below the 16 million vehicles expected by the 27 economists surveyed by Thomson Reuters. (Source: "December U.S. Auto Sales Miss Expectations," The Globe & Mail, January 3, 2014.)
Going into 2014, and looking at these warning signs, I am worried about key stock indices like the S&P 500. The easy money policies of the Federal Reserve have been largely responsible for 2013's rally in the key stock indices. But inadvertently, the Fed has created a new stock market bubble with its ridiculous, long-running money printing programs. Dear reader, the higher key stock indices go, the bigger the fall is going to be and the bigger the damage will be to consumer confidence and spending.