Too Much Optimism?

01/12/2007 12:00 am EST

Focus:

Jon Markman

Editor, Trader's Advantage

Astute analyst Jon Markman writes that many global stock markets outperformed the US last year, and predicts the combination of weaker US economic growth and overwhelmingly bullish sentiment could be setting the market up for a correction...

"The recent weakness in US commodity prices would normally be a bit worrisome, as it suggests that investors fear economic growth may not be strong over the next few months. An economy that is not growing real fast does not need a lot of copper and steel.

"Yet the United States is no longer the world's largest consumer of commodities. Global economic growth has surpassed that of the US for many quarters now, and this divergence is unlikely to abate soon. This differential has shown up most vividly in stock prices around the globe.

"Half of the world's 80 largest stock exchanges rose more than 20% in 2006--much more than the 13% gain of the S&P 500 (INX) in the US. Markets that reflected strong gains from leadership change and/or growing entrepreneurship included Peru, up 168%; Vietnam, up 144%; China, up 121%; Costa Rica, up 77%; Morocco, up 56% and Mexico, up 49%. This differential between the performance of US and world stocks is likely to continue in 2007.

"My main concern starting off this year is the surplus of bullish sentiment combined with slowing economic growth. A Bloomberg reporter pointed out that strategists at 12 of the biggest Wall Street firms agree that US stocks will rally next year. The last year that happened was in 2001, when the Standard & Poor's 500 Index dropped 13%. Stocks can rise and have risen as US economic growth has fallen in past business cycles, but this typically occurs from a base in which sentiment is poor. A combination of positive sentiment and weak economic growth could be a problem.

"The rise in volatility and the signal from commodity prices should make us a bit cautious at the start of the year. I will be looking closely for signs of a minor top similar to what we saw in May of last year, although right now the evidence does not show that one is forming. My main concern would be if the S&P 500 fell to under 1395. Although by itself that would not seem like a big decline, it would open the door to a drop to the low 1300s.

"On the other hand, a decline of 10% to 15% is just what many investors would like right now to buy into the market. And you know, the majority of investors seldom get what they want."

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