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The Dow Industrials continues to struggle with resistance at 10,500. Every time it peeks above that level, the sellers step in. Friday was a great example. Stocks were up big on the surprise employment numbers. The Dow made it to 10,549. And then, even though that data was evidence that the U.S. economy is improving, stocks sold off.
What does this tell us?
In my opinion, it tells us two things. The first is that the positive employment news (and a range of other improvements to the economy) is priced into stocks. In other words, stocks are priced for the earnings gains implied by unemployment dropping to 10%.
It’s important to understand that once stocks are priced properly, there isn’t much upside. It’s already priced in. When stocks appear to be priced to perfection, investors stop focusing on the upside potential and, instead, start looking for threats to the upside scenario.
Like right now, we can see that unemployment is improving (or at least stabilizing), consumer spending is stabilizing, and the housing market is bottoming,
What are the threats to these developments? Well, there are a lot of delinquent mortgages facing foreclosure. If they hit the market, housing prices could tank again. Consumer spending, while not exceptionally strong, has been about as good as could be expected so far this holiday season. What if it’s just a matter of people blowing off some steam, spending a little after the year we’ve had? And what if interest rates rise in the next 6 months? How will that affect stocks and the economy?
*****I’m not saying all these examples of threats to the economy truly exist, or will happen. It’s just that nothing’s perfect (at least not for long), especially in the stock market. And after the last couple of years, it shouldn’t be a surprise that investors may be wondering what could go wrong.
*****The second thing stocks are telling us right now is that mutual funds, hedge funds, and pension funds have all had a good year. They’ve made money so their clients aren’t standing out front with torches and pitchforks anymore. Institutional investors are taking some profits as the end of the year approaches. They’re locking in some gains so they can say yes, we had a good year.
That’s just good business. It doesn’t necessarily mean they have their clients’ best interest at heart. The fund business is highly competitive. After the rally we’ve had this year, if you haven’t locked in concrete gains, you could be out of business whether stocks head higher or not.
*****Now, here’s the interesting thing. Just because the institutional crowd is taking some profits does not mean the stock market is facing an imminent downward slide. In fact, rising skepticism, profit-taking and portfolio maintenance can be considered bullish. If the economy does better than expected, and earnings estimates are too low, we’ll see another powerful move higher. And I remain cautiously optimistic on the U.S. economy.
Does that mean I’m not buying any new stocks? Again, no it doesn’t. The only way you have winners to sell is by buying stocks in the first place. I have continued to recommend quality stocks at attractive prices throughout the rally. Just because many stocks appear properly priced, does not mean that there aren’t many attractive values out there.
*****One more thing. Right now, a lot of investors are worried about interest rates rising. I admit I’ve talked about rising rates as a negative here in Daily Profit. But let’s not lose sight of the fact that this discussion is arising because the economy is finally showing signs of improvement. It’s not realistic to think that if rates increase to 1%, they will choke the economy. It just means that there is less risk of an economic meltdown so the Fed can tighten a bit. If anything, that’s bullish for our economy.