Back on June 5, when fear was palpable following a sharp market retreat, I suggested that it was a good time to buy stocks.
Since then, the market has advanced an impressive 15%. I hope you got more long exposure to stocks back then, and you've enjoyed the upside.
Now, however, it's time to take some money off the table. How so? After all, Europe seems to be stabilizing, and the Fed just announced another round of quantitative easing, or QE3. All of this is reassuring, right?
Maybe, but I see four solid reasons for a pullback here. 1) Insiders are turning decidedly bearish. 2) Investors are turning much more bullish, a contrarian signal. Technical indicators support this, suggesting that the market is toppy. 3) Third quarter earnings will show a lot more weakness than many investors expect. 4) The same market strategist who made the bullish call back in June has turned bearish -- Michael Painchaud of Market Profile Theorems, who has a decent record at calling market turns. "We are now in a distribution phase," he maintains.
So, what to do with your stock portfolio? In short: Risk off.
It's a good time to be selling trading positions, buying long-dated out-of-the-money puts, or moving into "safer" dividend plays which can do ok in corrections, as other investors gravitate toward them. I've recently suggested Philip Morris (PM), McDonald's (MCD), and Coca-Cola (KO). I'll offer buy limits and more details on these three stocks in a second. But first let's look at the big picture, and why the market is about to retreat.
* Insiders are turning bearish. As the market has moved higher, insiders have stepped up their selling, especially in relation to how much they are buying. This is not a good sign. Two insider sentiment indicators tracked by Vickers Weekly Insider, published by Argus Research, have turned the most bearish they have been since early May, when the last correction got underway.
* Investors are turning much more bullish. Painchaud has his own proprietary measures that show this trend, which he does not share. But we can also see this in investor sentiment surveys published by American Association of Individual Investors and Investors Intelligence, and in the declining put-call ratio. Plus, short interest in stocks is currently near the low end of its multi-year range, according to Bespoke Investment Group. Technical indicators like overbought-oversold measures, the number of stocks making new highs compared to those making new lows and price, and the advance-decline line support the view that the market looks toppy, says Painchaud, at Market Profile Theorems.
* Earnings will disappoint. Painchaud tracks trends in earnings estimate revisions and surprises, and the trends are not good. They show an ongoing deceleration. "This tells us that earnings are not going to support the multiples in the market," says Painchaud. "We expect a very poor third quarter reporting season." Already, we've seen negative surprises or bad preannouncements from Intel (INTC), Norfolk Southern (NSC), and FedEx (FDX). This is a bad sign since Intel is consumer facing, and Norfolk and FedEx are good economic bellwethers, as shipping stocks.
How bad will things get?
Painchaud projects an 18-month correction that could take stocks down 30%. Part of his reasoning is that stocks and the economy are often weak in the first year of the presidential cycle. The theory is that incumbent presidents try to pump up the economy as much as possible in their fourth year to get reelected. Conversely, they try get all the bad stuff out of the way in the first year, which can weigh on the economy.
I think a projection for an 18-month bear market taking stocks down 30% is too dire, given the progress in Europe, and the Fed's new QE3 commitment to spend up to $40 billion per month buying debt, as long as it takes to move employment to acceptable levels. Indeed, euphoria surrounding QE3 could support investor sentiment and stocks following a near-term correction.
But there's a potential problem here, responds Painchaud. What if inflation starts to rear up? That's not so farfetched. The Fed and Washington have pumped huge amounts of stimulus into the system. Energy prices have remained elevated long enough to start bleeding over significantly into the price of goods and services soon. A significant portion of the consumer price index inflation measure is housing, and home prices and rents have been moving up significantly in many markets. In short, the big inflation scenario is potentially real. Since the Fed follows a dual mandate of supporting employment and containing inflation, big inflation would have investors worrying the Fed will take away QE3, which would spark selling in stocks.
If you want to maintain exposure to stocks in a correction, or hedge by staying in some stocks in case a pullback does not play out, it makes sense to own "steady Eddie" dividend payers that can hold up better. They also continue to pay you, despite pullbacks. Here's a quick look at three stocks, all of which I own.
Philip Morris, Buy Below $88.50
Philip Morris has done very well since I first suggested it in early January 2011. It is now up 57% compared to 14.6% gains for the S&P 500. But I still like it at $88.50 or below. This is a solid stock for capital appreciation and income. Philip Morris has the international rights to extremely popular cigarette brands like Marlboro, which makes it a play on emerging market economic strength and the emergence of a middle class in emerging markets. Both of these are multi-year, long-wave trends, which I believe are worth getting exposure to, as long as you don't have moral qualms about owning a tobacco company. It pays a 3.7% yield.
McDonald's, Buy Below $88
McDonald's has pulled back from around $102 earlier this year, to trade recently at about $88, as investors worry about problems in Europe. Typically, though, McDonald's can pick up market share during economic slowdowns. The reason: It is so big that it has power over suppliers to keep costs down. So it can entice consumers with discounts better than competitors can. Behind the scenes, its "Innovation Center" test kitchen should continue to roll out popular products. It pays a 3% yield.
Coca-Cola, Buy Below: $38.50
Coca-Cola is up about 30% since I first suggested it in November 2010, compared to 21% gains for the S&P 500, but it has more to go to the upside. Coca-Cola has an economic moat in its global distribution network and powerful brands. The kicker is that Coca-Cola continues to invest and expand in emerging markets like China, Russia, and Brazil. That makes this iconic American brand an emerging market play, and play on the emerging middle class. This is a classic long-wave investing trend worth investing in.
By Michael Brush
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