With the stock market closing last week at multiyear highs, and very close to all-time highs, investors may question whether this rally can continue. I see three major reasons to believe it won’t.
The Dow ended 2012 at 13,104 and ended January at 13,860, resulting in a powerful start to 2013 and a gain of 5.77 percent for the month. The Standard & Poor’s 500 also had a strong start to the year, gaining 71 points in January, for a 4.98 percent increase. The Nasdaq Composite, which is very technology-heavy, underperformed the other two major indexes, adding 122 points for a 4 percent gain.
While there is a historical precedent — the January Effect — which states that stocks usually do well in years in which their January performance is strong, there are at least three major reasons to believe this year could be different. In fact, based on these three reasons, we could be in for a significant correction in the near-term.
Stocks not only generated great returns in January, but they’re now at multiyear highs and are very close to all-time highs. The Dow ended last week at 14,009, just 155 points, or 1.5 percent, below its all-time closing high of 14,164. The S&P 500 ended the week at 1,513, just 52 points, or 3.4 percent, from its all-time closing high of 1,565.
The first of my three reasons for being cautious here is based on technical analysis — price and volume-related analysis of the Dow and S&P 500. With the Dow and S&P 500 very near all-time highs, they are both making double tops. Double tops are represented by chart patterns that show historical trading of, in this case, these two indexes. A top forms when the index trades up to a price level and then declines. Tops can form quickly, or can take months to build. Once a top has formed and the index declines from that price level, a level of resistance is established at that top, which is difficult for the index to push up through from that point forward. For example, the Dow made its all-time high at 14,164. This level is a top and represents resistance for the Dow; it will be very difficult for the Dow to trade up through that level.
Both the Dow and S&P 500 are forming what is known as a double top because they are approaching their all-time highs, so two peaks are visible on the nearby 10-year chart of the Dow:
The amount of time in between the two tops is also significant; the longer it has been, the more difficult it will be for the index to push up through the previous high. The all-time highs for the Dow and the S&P 500 were set in October 2007, so it has been a long time!
In this case, we have a top, a multiyear high and an all-time high all rolled into one, making the amount of resistance very, very significant at these levels — meaning it will be really hard for these indexes to push through these all-time highs. Normally it takes several attempts for an index to push through a high like this, each of which is followed by a correction of some magnitude, before it finally can push to new highs.
For those who think technical analysis is witchcraft, there are two other significant reasons to be concerned about stocks.
The second major concern I have related to the economy. We received the preliminary report on fourth quarter gross-domestic product last week, which shocked everyone, coming in at -0.1 percent. Economists, on average, were expecting growth of 1 percent. Even though stocks shrugged off this report, there can be no doubt that serious damage was done to the economy during the fourth quarter as a result of the “fiscal cliff” debate and Hurricane Sandy’s aftermath.
Higher taxes, as a result of the fiscal cliff debate, as well as the increase in payroll taxes to 6.2 percent from 4.2 percent, resulting from the end of the payroll tax holiday that lasted two years, will certainly weaken the economy in 2013 and beyond.
The acceleration of dividend payments into the fourth quarter, again as a result of the fiscal cliff, means that dividend income that would have been received throughout 2013 was received in the fourth quarter. This means consumers will have less money in future periods than they otherwise would have had, again negatively affecting spending.
The flu (I know this sounds silly) is having a very negative impact on the economy, too. By some expert accounts, the flu, which is the worst in at least a decade, could reduce GDP this year to as low as 0.7 percent growth from 2 percent growth.
The third reason stocks may correct shortly is the pending fiscal cliff hangover debate coming this month. Spending cuts that were scheduled to go into effect at the beginning of this year will automatically go into effect at the beginning of March, unless Congress can agree on some alternative plan.
Regardless of what is ultimately decided, the uncertainty surrounding the outcome could be enough to cause a correction in stocks. If they fail to agree on something, the spending cuts will go into effect, negatively affecting the economy. If they decide to allow any of the cuts to go into effect, there will still be some negative impact on the economy — less spending means less economic growth.
Even if Congress decides to postpone the spending cuts, there is no doubt that some serious spending cuts are needed to get the budget deficit and national debt under control, and any spending cuts, even those scheduled for the future, will worry investors. Any way we slice this, the threat of spending cuts is enough to cause a correction in stocks.
Taken as a whole, the short-term environment for stocks is concerning. Although there is potential for stocks to make new highs and then trade up into a new, higher trading range, I don’t believe the upside from here is significant, at least in the short run. Therefore, again in the short-term, downside far outweighs upside, so the risk/reward tradeoff is unfavorable.
The silver lining to this story is that, if I am right and stocks correct, there should be a great opportunity to invest after that correction and enjoy some significant upside. Bonds, in my opinion, are in a bubble, and with rising interest rates to come, real estate and commodities do not look good either. This leaves stocks as the most likely recipient of cash coming out of these other asset classes. Couple these cash inflows with better valuations resulting from a correction and we have the makings of a strong stock market rally. Time will tell, but if I am correct, we should see stocks begin to sell off sometime in February, so we won’t have to wait long.