Don't be Tempted by Exuberance

03/07/2013 11:00 am EST

Focus: MARKETS

Doug Fabian

Editor, Successful ETF Investing, ETF Trader's Edge, Weekly ETF Report, and ETFU.com

This market looks overbought, and the party can't last forever, so the smart strategy is to pull back and regroup, writes Doug Fabian of Successful Investing.

The bulls are dancing on Wall Street, and everybody seems to love the 2013 buying party.

While the financial press is touting this earnings quarter as strong, recent statistical analysis from Goldman Sachs indicates otherwise. Despite the real earnings picture, optimism on Wall Street reigns supreme, even in the face of an increasing unemployment rate and fourth-quarter GDP data showing the economy contracted by 0.1%.

So, the question is: why all of the big buying in stocks, despite the afore-mentioned negatives?

I suspect that the main driver is the easy-money policies of the Federal Reserve, which have helped Wall Street gain access to plenty of low-cost capital that can be used to buy stocks. But in terms of the real economy, things haven't been so great.

Yet, stocks have raced into what clearly is an overbought status, trading at levels they haven't seen since 2007. I think it would be a severe mistake to jump headlong into this equity-buying party.

It was the same bullish attitudes that caused far too much complacence among investors right before the 2008 market implosion. To be clear, I am not saying that 2013 will be a repeat of 2008. But in 2008—as is the case today—investors were largely of the opinion that nothing could possibly go wrong, and that stocks were headed up in perpetuity.

According to a recent Bloomberg survey, investors are as bullish on stocks as they have been in at least 3 1/2 years, with close to two-thirds planning to raise their equity holdings in the next six months. The poll also showed that 53% of respondents say equities will offer the highest return in the next year. That’s a 17-point jump from November’s poll, and the highest since Bloomberg began the quarterly survey in July 2009.

Professional managers also are bullish to the extreme. According to the National Association of Active Investment Managers (NAAIM), the reading is the highest it's been in years—another indicator that bullish sentiment has become unsustainably exuberant.

The Conference Board reported that its index of consumer confidence fell to 58.6 from an upwardly revised 66.7 in December, well short of economists' expectations of 64. This is the lowest reading since November 2011.

Meanwhile, domestic stocks continue to march higher. The divergence between consumer sentiment and the stock market has become quite pronounced—a condition that also is unlikely to be sustainable over the long term. Ultimately, weak sentiment results in lower sales, which will pinch companies' bottom lines and stock prices.

Here are a few additional factors that we see holding equity markets down during the short run:

  • Energy prices have been on the rise, with WTI crude oil at the highest level since September.
  • Regional manufacturing data isn't showing much improvement. The Richmond Fed index came in well below expectations, as did the Philadelphia Fed Survey and the Empire State Manufacturing Survey.
  • Technically speaking, we are near a point where stocks are way overbought and due for a substantive pullback.

Remember, it is during times when investors harbor unbridled bullish enthusiasm that—seemingly out of nowhere—an exogenous event pops up to slap investors back into recognizing the error of their ways.

By remaining cautious with our equity allocations, we are in a position to avoid the damage done by a market sell-off—a sell-off that we can subsequently take advantage of, once stock prices settle in to more rational levels.

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