US Market Is Nowhere Near a Top

05/26/2011 11:00 am EST

Focus: MARKETS

Bernie Schaeffer

Chairman and CEO, Schaeffer's Investment Research

The S&P 500 is headed for a record high by year’s end, despite worrisome weakness in emerging markets, writes Bernie Schaeffer of Schaeffer’s Investment Research.

Once again this year, I had the pleasure of delivering a keynote at the MoneyShow Las Vegas. Read on to learn why I think we still haven't found that elusive market top, and where I think the major market indexes are headed through the end of the year.

The stock market, as measured by the S&P 500 index, is in excellent technical condition.

The S&P 500 is currently trading about 10% above its key 80-month moving average—a long-term trendline that has been remarkably successful at defining the health of the market.

Compared with the current 10% gap, the S&P traded at nearly double its 80-month moving average in the 1980s and 1990s, and in 2007 it peaked about 35% above this trendline. The current modest premium should give comfort to those who fear the market has come "too far, too fast" off its 2009 bottom.

Another source of comfort to the bulls is the longer-term volatility of the S&P—which, as measured over the past 14 months, is still two to three times the lows in volatility over the past 25 years, and more than twice the volatility level at the October 2007 market top.

Many analysts have described current "low" volatility levels as indicating a "dangerous complacency" among investors, but the historical data says otherwise.

It is also important to note that the market reached its most oversold levels of the modern era in early 2009. The overbought peaks over the past 25 years occurred at much more extreme levels than the market's current reading.

While the price action of the market is strong, with no indication of the chart excesses that would suggest a market top, as confirmation of this view we need to look at the sentiment backdrop. This is particularly important in gauging the potential for buyers to power the market even higher.

As I've said many times, "The charts always look pretty at market tops."

In general, the degree of disbelief associated with the huge rally off the March 2009 bottom—a rally in which the Russell 2000 index has more than doubled—has been unprecedented in my decades of tracking investor sentiment.

NEXT: Good News: The Media Hates Stocks

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Good News: The Media Hates Stocks
The extremely bearish Time cover story in October 2009, "Why It's Time to Retire the 401(k)," has the potential to be a generational bullish contrarian media piece, as dead-wrong as the notorious 1979 BusinessWeek "Death of Equities" cover story just before a 15-fold rally in the S&P 500 over the next 20 years.

In each case, the media was reflecting the view that the market had proven itself a failure as a mechanism for building wealth.

Investors have shunned equity mutual funds and still show a clear preference for so-called "safe assets,” with bond funds experiencing a $604 billion inflow since 2008 and domestic equity funds showing a $347 billion outflow from 2007 to 2010.

And while hedge-fund assets are back to their 2008 peak of about $2 trillion, there is strong evidence that these behemoths have lower exposure to equities than at the 2007 market peak. The major clues are:

  • a reduced level of short interest (which, perversely, is a good indicator of the long exposure of hedge funds)
  • a decline in the number of index put contracts that are used to hedge long stock positions
  • and hedge-fund underperformance in the first quarter, in which they posted a 2% gain compared to 5% for the S&P 500

There are four stages of investor sentiment as the market moves from bottoms to tops. The dominant sentiment at bear-market bottoms is despair; the initial rally off the bottom is then met with disbelief. The rally finally goes through the acceptance phase, and the final warning sign that a top is at hand is investor euphoria.

To suggest we are at a market top before this rally has been fully accepted by mainstream investors is to believe we are going to skip the "euphoria stage" this time around, and I see this as highly unlikely.

I'll also suggest the fact that we're in the third year of a Presidential term—which, since 1949, has produced a positive return in all 15 of its occurrences, for an average market gain of 17.7%—does nothing to discourage a bullish outlook for the remainder of 2011.

I'm targeting an additional stock market gain of 15% to 20% through year-end, which in the process would carry the S&P 500 to an all-time high, the Dow Jones Industrial Average to 15,000, and the Russell 2000 to 1,000.

The Emerging Fly in Ointment
The emerging markets— through their iShares MSCI Emerging Markets Index Fund (EEM) proxy—are presenting a different picture that I feel is a concern for this segment of the market, if not for its US counterparts. The EEM has struggled all year, and it moved back into negative territory recently and is now showing a 2% year-to-date loss.

An additional concern for contrarians is the fact that even as money has steadily flowed out of domestic US equity funds, money flows into overseas equity funds have remained positive. And some fundamental-based players are beginning to express concerns about the magnitude and direction of interest rates in the so-called BRIC (Brazil, Russia, India and China) nations, which form the cornerstone for the emerging markets.

I remain bullish on US equities, but I'd be quite cautious about exposure to emerging markets, and I'll be watching the action in EEM very carefully as a potential "fly in the ointment" to my bullish domestic view.

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