The area was known to be an idyllic sanctuary. Snowcapped mountains, crystal clear lakes, warm summers, a gentle autumn ... you get the picture. For nearly 180 years, Mount St. Helens remained silent, towering over the beautiful scenery below.
However, there were early warning signs pointing towards a potentially catastrophic eruption of the volcano. Most viewed them as nothing more than hot air (no pun intended).
Doug, a farmer who lived close to the foot of the mountain refused to evacuate. 'My mountain wouldn't do that to me' he said. Less than 24 hours later, Doug and his farm were buried beneath 70 feet of mud and volcanic debris.
What's the moral of this story?
1) Even subtle signs can foreshadow a significant event
2) Just because an event doesn't occur regularly doesn't mean it can't happen.
What does the 1980 eruption of Mount St. Helens have to do with the stock market? More than you'd think.
Subtle Signs - Significant Results
Do you remember how stocks (NYSEArca: VTI - News) slowly but steadily inched towards their April 26 highs? For nearly two months (from 2-26-10 to 4-15-10) the S&P (SNP: ^GSPC) moved up without more than a 0.5% down day. The picture for the Dow (DJI: ^DJI) and Nasdaq (Nasdaq: ^IXIC) looked similar.
Beneath the surface of rising prices, however, trouble was brewing. On Wednesday, April 14, the CBOE Equity Put/Call Ratio dropped to 0.32, the lowest reading in nearly two years and was 45% below its six-month average.
On April 16, the ETF Profit Strategy Newsletter picked up the subtle put/call ratio warning signal and published this cautionary note: 'Only a minority of equity positions are equipped with a put safety net. Once prices do fall and investors do get afraid of incurring losses, the only option is to sell. Selling, results in more selling. This negative feedback loop usually results in rapidly falling prices.'
The 22 trading days following the April 26 market highs erased eight months worth of gains. Bear markets move much quicker than bull markets.
Rule #1: Better too Early than too Late
When preparing for a bear market (we'll discuss in a moment why we have been preparing for a bear market), it is prudent to start early. Anyone who sold their long positions as early as September last year would be in a better position than the buy-and hold crowd that is still clinging to their holdings.
Rule #2: Don't Trust Wall Street and the Media
By now, even the mainstream media is sensing that something might not be quite right with the market's performance. However, there is still hope that the second half of the year will get a lift from positive earning results.
Before you bet your money on that line of reasoning, consider the picture the media painted days within the April 2010 market top.
April 19, 2010
'America is back - The remarkable tale of an economic turnaround' - Newsweek
'Recovery tilting to V-shape as profits prompts growth revision' - Bloomberg
April 25, 2010:
'U.S. stocks cheapest since 1990 on analyst estimates' - Bloomberg
'Technical Analysts see room to roll' - Wall Street Journal
April 27, 2010
'Greece contagion fears unfounded' - Reuters
May 3, 2010:
'Manufacturing in U.S. grows at fastest pace since 2004 as recovery gains traction' - Bloomberg
Over the past two and a half months, the S&P (NYSEArca: SPY - News) and Dow (NYSEArca: DIA - News) have lost as much as 17%. A 20% loss is considered the mark of a new bear market. In essence, we are only one bad day away from the next bear.
Of course, throughout the massive bear market rally from the March 2009 lows, which the ETF Profit Strategy Newsletter predicted via the March 2, 2009 Trend Change Alert, the newsletter maintained that it was only a bear market trap which would fool a majority of investors.
On April 16 it stated that 'Most bulls have no clue why they are bullish except for the fact that they feel the need to play the momentum game. Sounds like 2000 and 2007 all over again. The message conveyed by the composite bullishness is unmistakably bearish.'
Rule #3: Don't Underestimate Cash
In a period of falling prices, cash or cash equivalents like short term Treasuries (NYSEArca: SHY - News) maintain your purchasing power - long-term Treasuries (NYSEArca: TLT - News) are interest rate sensitive and may move faster than you think.
When stocks fall and you are able to maintain your purchasing power, you are able to buy stocks at a discount. In essence, cash offers a positive return in periods of falling prices.
Additionally, or alternatively, investors may choose to buy short or leveraged short ETFs such as the Short S&P 500 ProShares (NYSEArca: SH - News), UltraShort Russell 2000 ProShares (NYSEArca: TWM - News) UltraShort S&P 500 ProShares (NYSEArca: SDS - News), Short Financial ProShares (NYSEArca: SEF - News), Direxion Daily Financial Bear 3x Shares (NYSEArca: FAZ - News) and many more.
Rule #4: Don't Procrastinate
On May 14, the ETF Profit Strategy Newsletter predicted that the S&P (NYSEArca: IVV - News) will fall through the important 1,040 resistance level. Aside from a small cluster of resistances (one being round number resistance), a break below 1,040 opened the door wide for significantly lower prices.
We mentioned above that we've been preparing for a reemerging bear market even before the April highs. Why?
Simply put, stocks are overvalued. How can that be? One of the above headlines read that U.S. stocks are cheapest since 1990, at least according to analyst projections.
The key word is projections. Analysts project operating earnings for the S&P to clock in at $94.83 in 2011. This is higher than the 2007 peak of $91.47. That's right, despite record high unemployment, a European (NYSEArca: VGK - News) debt crisis, a 17% U.S. market correction, and all the other problems economists expect corporate profits will exceed their 2007 all-time highs. Does that sound reasonable to you?
Keep in mind that projected earnings are just that - projected. They can and will change. In fact, analysts have a reputation of following the trend.
In April 2008, analysts predicted earnings of $113. After cutting its forecast to $53, Goldman Sachs cut its earnings forecast to $40 in March 2009. As we know today, stocks rallied, and actual 2009 earnings came in at $56.87.
The list goes on, but the simple message is that analysts tend to be overly optimistic before the fall and overly pessimistic before a rally. Right now they are overly optimistic. The conclusion is easy.
Rule #5: Know who to Trust
Even when basing the current P/E ratio on overly optimistic estimates, it is still far away from the P/E ratios seen at historic market bottoms. The same holds true for dividend yields. A look at various valuation measures shows that the market is overvalued by much more than just 10 or 20%.
The ETF Profit Strategy Newsletter provides a detailed analysis of four valuation metrics with a near spotless track record of historic accuracy. The Newsletter also includes a target range for the ultimate market bottom and the one chart that highlights the short-term bearish potential.
Will you head the warnings signs, or like farmer Doug trust that the market won't fall on you?
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