It's time for some insight.
I'm constantly asked where I think the stock market is going next. Since the Dow recently reached new highs and the S&P 500 is pushing its old October 2007 highs, it's no wonder that's the question on everyone's mind and lips.
My answer is: I don't know where it's going. But I do know what to do about it.
Here's the thing...
The stock market is like the lottery, you've got to be in it to win it. And that includes being out of it at times, too.
That's not contradictory. Here's why. Being fully invested is taking a big position. Being partially invested is taking a smaller position. Being out altogether is still a position.
That's how professional traders think. Everything you do puts you in a position. Being in cash is a position every bit as much as being fully invested is having a position.
What's important - and what all successful traders do - is to watch your position.
If you're in stocks, what is your exit strategy on the profit side? On the loss side?
How are your stocks performing relative to firm-specific issues or the market's general trend?
Equally important-as in always, always-is when and where to apply that cash?
With that in mind, here's what I'm looking at as we hit record after record - and what I recommend doing about it.
First you must ask yourself:
Why have markets risen while domestic economic growth has been stagnant? What is moving markets higher? And what can change?
The Fed has been keeping interest rates for interbank lending and borrowing at essentially zero. That drives down all interest rates. They're doing that by buying government bonds and agency paper - meaning government guaranteed mortgage-backed securities. They're buying $85 billion worth per month, and they expect to keep it up.
What the Fed is doing, besides prodding consumers to spend in an attempt to keep access to installment credit cheap, is supporting a recovery in the banks' balance sheets. The Fed is giving them cheap money to buy the same government bonds they're buying, so banks' inventory of bonds will appreciate along with paying them interest. By buying agency paper, they're supporting the valuation of mortgage-backed securities on the banks' balance sheets, hopefully long enough to see housing - and those bond prices - bounce back.
The by-product of the Fed's action has been articulated as its primary intention, which, they say, is to help drive up markets, confidence, and the economy.
It's been working for the markets, but not so much for the economy. Why?
Because banks are more interested in themselves and repairing their balance sheets (in other words, making safe money) than lending at low rates.
They are not in the lending business, especially loans to small businesses and consumers - unless it's through revolving credit lines, dispensed with myriad penalties and exorbitant interest rates through credit card issuance. They're not into allocating capital to borrowers, either, as much as they're into creating products. There's a big difference.
Fortunately for corporations, earnings have been great. And with low interest rates they have been able to refinance higher-interest debt and amass large quantities of cash.
Incidentally, that's not good for banks. When corporations have positive cash flows, when they are flush with earnings and sitting on reserves, they don't need to borrow from banks.
A lot of corporate earnings are coming from overseas. That's been good on account of slow domestic growth.
But, those earnings have benefited from a weak dollar. As other countries work to devalue their currencies to make their exports cheaper, and as the dollar continue to strengthen, overseas earnings-when translated into a more expensive dollar-will not be as robust as they have been. On top of that, if global growth falters, earnings will take a bigger hit.
The domestic hope is that housing is bouncing. That's important because in spite of the $10 trillion in growth from a rising market, fewer and fewer people are actually in the market other than in their pension and retirement funds. Average Americans need a robust housing market; it's where the bulk of their wealth has traditionally resided.
I worry about banks not lending to potential homebuyers, which can cause housing to stall. I worry about contagion from the ongoing mess in Europe. Cyprus is a real problem. It is another canary in the coalmine, like Greece was. Europe's problems are not going away.
American growth isn't likely to be robust if the banks aren't lending, and if fiscal restraint (à la Europe's belt-tightening) slows the meek forward momentum that the economy has seen.
That's what worries me about the market being as high as it is - and its prospects for going higher still.
Then again, there is so much sidelined cash, a lot of which is heading back into equities, and the prospect that low rates will see an exodus out of bonds and into stocks, the Great Rotation, that markets have potentially plenty of firepower to go higher. In fact they could go a lot higher.
So, what am I recommending?
- Follow the big trends and trade on the same side, starting with the big macro trends all the way down to the minor trends within bigger trends, if they're all going the same way.
- The markets are going up, so stay in them. Get out as you take profits when your positions slip back and hit the stops you always should be raising as the market rises.
- Apply your cash diligently and sparingly to new positions, especially if they are speculative.
- Take small losses on new positions when you get in. You're late to the party, but the punchbowl is still out there and heavily spiked, so join in but do so incrementally.
- If you're putting on defensive positions (hopefully they pay solid dividends), add to them on dips. But think about an exit strategy if the big picture turns negative.
We may not get a significant correction, in which case you want to be riding this bull market higher.
Then again, the markets love to sucker in sidelined cash right before they crash.
Is a crash possible? Yes it is.
There are technical reasons why the markets are shaky. I'm not talking about technical analysis. I'm talking about high-frequency trading trends and the massive growth of ETFs. The interplay between them is a danger zone that could undermine markets in a New York second.
When it comes to the market, I know I don't know which way it's going, but I always manage to make money when it goes in either direction. My trick is to follow the trend and follow that nagging feeling I get when the trend shows cracks that not everyone else sees.
Related Articles and News:
- Money Morning:
The Great Rotation Makes Stocks a Generational Buy
- Money Morning:
What You Absolutely Need to Know About Money (Part Three)
- Money Morning:
What You Absolutely Need to Know About "Their Paper Money"
- Money Morning:
What Everyone Absolutely Needs to Know About Money