Time to be Cautious of US Stocks

I have been quite bullish on the US economy and US stocks over the past couple of years. I viewed every correction as an opportunity to increase my long position. In fact, the near 10% correction in October got me 90% invested – one of my highest exposures to US stocks ever.

That sell off got me particularly excited because it was just before the most seasonally bullish period: the first 6 months of the pre-election year of the presidential cycle. As the following chart by Ryan Detrick shows, since 1950 the market has gained every time during the November to April period of the 3rd year.

Presidential Cycle Returns-2

With April ending last week, true to form, the market gained once again during the past 6 months, although by only 3.3%. Last week I decided to do some significantly selling so that I am now only 25% net long. However, I plan to remain long all the stocks listed in the trades section.

My cautiousness stems from not only from the seasonally unfavorable May to October period, but also due to sentiment and valuation. One important sentiment indicator, insider transactions ratio, shows that executives are selling much more of their own shares than buying.

Insider Transactions Ratio

In addition, Investors Intelligence survey of financial advisors and newsletter writers shows bears are near historic lows.

Investor Intelligence Bears

And the Hulbert Stock Newsletter Sentiment Index also confirms that bullishness is prevalent in the investment community today.

HSNSI 4:24:15

Valuation also presents a near term obstacle for stocks as the collapse in oil prices and the surge in the US dollar has caused S&P 500 earnings to decline while the market remains near record highs. As a result, the market is trading at 18x forward earnings estimates compared to the long term average of 16x. And there is a good chance that estimates of record earnings in Q3 and Q4 could be slashed.

An important support for stocks during this bull market has been the ‘Fed put’. That is, whenever stocks sold off or the economy weakened the Fed was ready to stimulate the economy with QE or pushing out market expectations of rate hikes. While that put still exists, I would argue that there is also now a ‘Fed call’ in play. If the economy or stock market were to heat up, the Fed stands ready to increase rates thereby capping the upside returns to stocks.

I want to be clear that I remain bullish on the US economy and stocks (in the long term). And without an imminent recession or sky high equity valuations, a bear market looks unlikely. However, sentiment measures and high valuations underscore the need for a 5-15% multi-month correction to refresh the bull market.

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