Bullish Sentiment Is Very High – Don’t Get Sucked In!

January 6, 2010

The market wants to move higher, but it just can’t seem to generate enough buying to blow through this resistance level. The news has been decent and seasonal patterns are strong. There are two reasons for this, profit-taking and valuations.

After a 70% rally off of the low, investors are taking some of their chips off of the table. Given the dire situation last year, they are happy to have recouped much of their losses. As the momentum has slowed, they are prudently reducing risk.

Valuations are priced for a full recovery. Any hiccup in economic activity will instantly weigh on stocks. Many analysts have reached their targets and they are systematically scaling out of positions. Earnings are just around the corner and they will kick off next Monday when Alcoa announces. It is possible that we will see a 200% gain in net income year-over-year. Q4 earnings for the S&P 500 came in around $5 last year and this quarter they could hit $16. The comps from 2008 were very easy to beat and a year ago we were in the heart of the financial crisis. Normally, a 200% spike in profits would spark massive buying. Last quarter, we saw a substantial year-over-year increase in earnings and stocks barely budged. That’s because stocks were fully priced.

Bank stocks will dominate the first two weeks of earnings and they have lagged the market. There is a chance that they will rally after the release. This will marginally push the market to new highs. Once tech stocks start releasing, the market rally will stall. The NASDAQ has surged higher and it broke out to new highs before the S&P 500 did. Fantastic results are priced in. Cyclical stocks have been moving higher and they will continue to as long as investors believe in the economic recovery. The earnings for these companies have been slow to recover, but that has not dampened spirits – yet.

This morning, the ADP employment index showed a loss of 83,000 jobs in the private sector. Analysts had expected a loss of 90,000 jobs and the number was slightly better than expected. In recent months, ADP has vastly under estimated employment and that means we could still see job growth (a positive number) in the Unemployment Report Friday. ISM services came in at 50.1 and that is slightly below estimates. It is an improvement over last month and it shows expansion in the service sector. This is important since services account for 80% of our economic activity. The market did not have much of a reaction to the releases.

Tomorrow, we get initial jobless claims. It will influence trading, but traders will be squaring up positions ahead of Friday’s number. The expectations for strong employment are supported by good initial claims the last two weeks. However, positive job growth does not mean the market will explode higher. Strong employment is likely to push bond yields higher and many analysts feel that any rise in interest rates could strangle this fragile economic recovery. Higher interest rates should keep the excitement in check.

The next two weeks could be bullish for the market. Higher employment and solid earnings growth are a good combination. However, it’s what lies ahead in Q2 that worries me.

I watch CNBC throughout the day and by my estimates 19 out of 20 guests are bullish. I can’t remember the last analyst who was bearish. Newsletter writers are also overwhelmingly bullish and confidence is running high. Option implied volatilities have hit 18 month lows. This means that put buying for protection or speculation is small. These conditions normally end with a dramatic market plunge because no one is looking for it. Consequently, I am keeping my powder dry. I don’t want to scramble for nickels as the market grinds higher only to have the rug pulled out from under me. Instead, I am lining up orders to purchase puts below technical support levels. When the big hurt comes, these orders will be triggered. If I’m wrong, I won’t lose any money as the market continues to work its way higher.

Overnight, the ECB said that it will not bail out Greece. The PIIGS (Portugal, Italy, Ireland, Greece and Spain) are a house of cards that is ready to crumble. This is exactly the type of event that could spark the decline and it was completely discounted by the market.

If you do plan on trading this market, buy commodity stocks (not options) and take profits by the end of the day.
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