U.S. Stock Market – Topping Action or Fuel for Record Highs?

Yesterday’s stock market losses were quickly recouped today as most major indices rebounded to test last Friday’s intra-day highs. Even though the Dow Jones Industrial Average failed to hold the closely-watched 14,000 level after late-day profit-taking, most market watchers and trading participants had to be impressed by today’s price action. With several major indices already in record high territory, can the DJIA and the S&P 500 now forge ahead to post their own record highs?

Here are today’s closing marks for four major indices, with changes from Monday’s close:

Dow Jones Industrial Average               13,979.30        +99.22             +0.71%

S&P 500 Index                                      1,511.29        +15.58             +1.04%

NASDAQ Composite Index                   3,171.58        +40.41             +1.29%

Russell 2000 Index                                    908.22        +  8.94             +0.99%

From today’s closing levels, the Dow Jones Industrial Average needs to rally about 188 points (+1.56%) and the S&P 500 needs to advance about 65 points (+4.29%) to post new record highs.

The bullish case for stocks is being pushed by Wall Street pundits as follows: (1) 4^th quarter earnings are coming in better than expected with about 69% of companies beating estimates, so far; (2) “Don’t fight the Fed! With short term interest rates near zero, where else can you invest your money?; (3) After a 30-year bull market, U.S. bond prices are poised to collapse (at least according to George Soros) and maybe there will be a “rotation” into stocks as investors reallocate cash from bond liquidations; (4) Equity-related mutual funds saw a record one-month inflow in January, so stock prices will advance as fund managers put this money to work.

None of the above listed reasons are compelling to me! However, stock prices could still advance despite my skepticism, and the Dow Jones Industrial Average may even post a record high before the next serious correction gets underway.

According to the latest estimate by Birinyi Associates (as reflected in the WSJ), the S&P 500 Index is currently trading at 13.57 x forward 12-month earnings. On the surface, this valuation would seem “fair” (and certainly not rich) according to historical norms. However, this forward P/E estimate assumes 2013 full-year earnings growth of 32% over the current trailing-twelve-month actual earnings. In my view, this optimistic growth forecast has almost no chance of being realized!

Tough to argue with point #4 above, but here is some “food for thought” on this argument. Yes, January 2013 was the best month ever in terms of net cash inflows into stock funds at +$55 billion. However, you may be surprised to hear that the second best month ever (the old record) was in February 2000. Some may remember that one of the greatest tops in the history of the market came one month later in March 2000.

I see that DELL was up a few pennies today at $13.42/share as the rumored leveraged buyout was finally announced. Feels like a “take under” to me. Dell is now down 77.5% from its record high set in March 2000 at $59.68/share. Not sure the shareholders are getting a fair shake here?

 

Bottom Line: Today’s rebound in U.S. stock prices was impressive, but I still think this rally is on borrowed time and that yesterday’s plunge was an important warning sign of the coming correction. While the current uptrend could continue, the risk/reward just doesn’t support meaningful allocations to equities right here. I understand that the 10-year T-note is yielding just 2.0% right now, but this “risk off” trade (buying short-term T-notes for safety and capital preservation) looks significantly more compelling to me right now than stocks or almost any other investment. Could that be a black swan I see on the horizon?