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An Early Warning Flag

Summary

To be clear, this is a strong bull market.

However, one of my fav long-term warning flags was just raised.

Coming into Monday morning, the S&P 500 was enjoying the best start to a calendar year since... wait for it... 1987. As of Monday's close, the S&P has gained... wait for it... 6% year-to-date. And according to Bespoke Investment Group, the S&P 500 is within... wait for it... 2.5% of the average Wall Street Strategist's year-end price target - this on January 22. To which, I'd like to say, "Yowza!"

By now, everybody knows the narrative. We've got synchronized global growth that continues to exceed expectations. A tax bill that looks to be additive from an economic standpoint. Earnings that have been beating the Street. Low inflation. Reasonable rates. Reduced regulation. Stronger oil prices. Excellent job growth. And money continues to flow into the stock market, because, well, where else is it gonna go? To which, most investors are now saying, Dilly Dilly!

Jim Cramer told his audience Monday afternoon that investors have to seize the moment and buy when stocks dip - even on an intraday basis. "Even in this market, this beast of a market, you do get the occasional buying opportunity. It does exist, but the window closes so fast that if you blink you'll miss it," Cramer said. "Still, if you're ready to pounce, you can pick up some high-quality stocks at discounted prices." (For the record, the S&P 500 was down 2.18 points at the low yesterday morning - a low that occurred in the first 2 minutes of trading.)

So there you have it; it's up, up, and away from here. As January goes, so goes the year. This market is unstoppable. And you have to "be ready to pounce" each time the indices dip a couple points - Booyah!

To which, I'd like to say, "Now wait just a doggone minute."

Hopefully, I have made my stance on the current environment clear in recent weeks. My bottom line is (A) it's a bull market until proven otherwise, (B) the trend is your friend - so it's okay to be long the stock market, and (C) as a risk manager, I see risk factors as being elevated at the present time. And for me, this means you should hold your positions, but, please, no turbochargers here.

One of the financial advisors I work with recently asked me if I wasn't guilty of being a bit over cautious. "Shouldn't we be jumping on the bull bandwagon with both feet and increasing risk plays here?" he asked. "And for the record, are there any specific indicators that are keeping you from being a raging bull?"

After a long sigh (which occurred only in my head), I explained that there were indeed many indicators that suggest this is not the time to be overly aggressive. "Again," I said, "I'm not talking about being negative or raising a bunch of cash. I'm merely suggesting that the risk of a meaningful correction is much higher than it was at this time last year."

I then pulled up a chart of my favorite valuation measure. It's a composite of valuation indicators which compares current valuation metrics such as earnings yield, dividend yield, book value, real earnings, real dividend, and a couple yield spreads to their trailing 10-year norms. While NO indicator or model should EVER be used in a vacuum, I pointed out that this particular valuation model flashed a sell signal on Friday - after being on a buy signal since early 2009.

I pointed out that while this type of signal tends to be early - oftentimes by many months - the indicator did flash signals before the market declines seen in 1974, 1977-78, 1981, 1984, 1987, 1998, and 2000.

Yes, it is true that this indicator doesn't have a perfect record (none do!). But it is worth noting that of the 11 sell signals the indicator would have produced since 1965, the market did decline 9 times. Oh, and the two times the market marched merrily higher after the sell signals occurred in the 1990's.

I then explained that I believe there are times to be really aggressive - such as at the ends of bear markets. There are times to enjoy the ride - such as during extended bull market runs. There are times to take less risk - such as when indicators start to break down in unison. And there are times to focus on preserving capital - such as when the bears are in control of Wall Street.

To drive the point home, I reminded my colleague that the tactical models we run employing this approach were aggressively positioned coming out of the 2015-16 mini-bear market. But as the current bull has aged, such an aggressive stance is no longer warranted - well, at least not in my book.

So, what will Ms. Market do next? I honestly don't know. However, I can tell you that I'd much rather keep an open mind and be ready for just about anything than be singing the bull tune at the top of my voice while convincing myself that nothing bad is ever going to happen again.

Thought For The Day:

If winning isn't everything, why do they keep score? -Vince Lombardi

Wishing you green screens and all the best for a great day,

David D. Moenning
Chief Investment Officer
Heritage Capital Research
Serving Financial Advisors since 1989
Serving individual investors since 1980
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Disclosure: At the time of publication, Mr. Moenning held long positions in the following securities mentioned: none.

Note that positions may change at any time.

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Disclosures

The opinions and forecasts expressed herein are those of Mr. David Moenning and may not actually come to pass. Mr. Moenning's opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report is for informational purposes only. No part of the material presented in this report is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed constitutes a solicitation to purchase or sell securities or any investment program.

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