Historical Reasons for Caution

01/28/2014 9:00 am EST

Focus: MARKETS

Projections by most Wall Street firms are for a continuation of the good times through 2014—a goldilocks market, neither too hot nor too cold, observes Sy Harding, editor of Street Smart Report.

We remain on the intermediate-term buy signal for the stock market. We expect favorable seasonality and continuing Fed support will sustain the bull market into April or May, but at increasing risk.

However, we would remind investors that the cycles between bull and bear markets have not gone away. For 100 years, a bear market has come along on average of every four and a half years.

We expect a serious market correction, potentially of bear market proportions, in this year's unfavorable summer season.

After two straight summers without a problem, which has pundits and investors ignoring its long time history and writing-off seasonality again as not meaningful, that correction will likely shock the majority.

Problems likely to create that correction are many and are not unknown, but are currently being glossed over. In addition to annual seasonality, they include:

Market Valuation: The Shiller P/E ratio is at a five-year high of 26.11. That's 58% higher than its historical mean of 16.5.

Investor Sentiment: The biggest outlier gain last year for the S&P 500 (SPX) since 1997, and one of the least volatile in history, has investors extremely bullish and confident.

Consensus Inc. Bullish Sentiment Index: This index was recently at 75%. Consensus Inc. considers 75% as the overbought level of potential market reversals. The Investors Intelligence Sentiment Index is at 59.6% bulls, 14.1% bears. The spread, 45.5, is in the 96th percentile of its highest historical readings.

Four-Year Presidential Cycle: Since 1934, the average decline in the second year of the cycle has been 21%.

The Aging Bull: The average lifespan of the 11 bull markets, since 1950, was 53 months. The current bull market is 58 months old.

For the second straight year, there was no intermediate-term correction. The largest 'pullback' was 5.7% from the September peak to the October low.

The result has been the unusual situation that, for the first time in, at least, 15 years, the S&P 500 did not revisit its long-term 200-day moving average even once during the year.

In bull markets, the support at the 200-day moving average is usually retested at least once a year, and it's not unusual for the support to even give way temporarily. So that it was not even tested was unusual. It adds to the risk as 2014 proceeds.

It would be well to realize that just a normal pullback to retest the support at the 200-day moving average would take the S&P 500 down to its level of October 16, wiping out the entire gain from mid-October.

Meanwhile, just the average 21% decline in the second year of the four-year Presidential Cycle would take the S&P back to its level of January 2, 2013, wiping out last year's entire big gain.

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