Oh, Damn: the Entire Stock Market’s Vulnerable to a Steep Decline

Late last year, some very smart investors, including some usually savvy hedge fund managers, doubted that stocks could rise much in 2012. As they initially sat on cash they would ordinarily invest, they paid dearly for their pessimism. The S&P 500 and the Nasdaq Composite indices are up some 20% in the past year; hedge fund returns are closer to break even. But there are signs now that those bears might be right yet; and that fewer investors are willing to chance that they are.

^SPX Chart

^SPX data by YCharts

Certain investor groups have quietly turned more bearish on stocks in recent weeks, although their selling so far has done little to hurt share prices. Corporate insiders have significantly ramped up the selling of their own shares, according to a report by Mark Hulbert at MarketWatch.

Similarly, mutual fund investors pulled $2.4 billion from the market in the week ending Oct. 4, marking the biggest of eight straight weeks of withdrawals.

Some investors simply assume the market has risen too fast considering known un-pleasantness on the horizon. In fact, these levels are rather close to forecasts from the more bullish analysts at the end of 2011, which clustered around the 15%-gain mark. Most everyone agrees that there is, or is about to be, the kind of financial and economic news that normally puts big gains in jeopardy. One key difference between bulls and bears here: their faith in investors’ willingness to take these sad facts in stride.

The first potential party poopers are third quarter company earnings reports that will be mostly lower than what investors had expected a few months ago. (Earnings season started this week.) Several companies, like Caterpillar (CAT), United Parcel Service (UPS) and manufacturer Cummins (CMI) already put out warnings to this effect, so bad numbers in many cases won’t shock. But unless corporate America generally promises that 4Q 2012 will be decidedly better, as analysts forecast, expect real selling to follow.

US Corporate Profits After Tax Chart

US Corporate Profits After Tax data by YCharts

Those forecasts of better days very soon – analysts estimate earnings will jump some 11% in 4Q and follow with decent early 2013 gains – are essential for the faith keepers. But several factors make such happy talk less convincing now than it was back in January.

In August, U.S. manufacturers made the biggest cuts to factory jobs that they have in two years. It’s indicative of not just a manufacturing slowdown, but of a pervasive problem that trickles down throughout the U.S. economy. Much of the world, including Europe and China, is simply less financially capable of buying our stuff this year than last. As a result, U.S. companies don’t need to hire more employees to make stuff, to package it, to transport it, or to sell it, no matter how much they get in tax breaks to do so. The laid off and wannabe U.S. workers have no money to buy the stuff either. It’s not a situation likely to improve much in the near future.

ADP Change in Nonfarm Payrolls Chart

ADP Change in Nonfarm Payrolls data by YCharts

The Federal Reserve action that has helped prop up share prices may go away post-presidential election.

Mitt Romney doesn’t like the market interference, and even Barak Obama’s Fed can’t be counted on to continue the program. It may not have been effective in providing economic growth as designed, but investors would surely miss the sort of price bounces they got after Fed intervention announcements in November 2008, March 2009, November 2010 late this August.

^SPX Chart

^SPX data by YCharts

But really, the hands-down biggest threats to share prices are the year-end government spending cuts and tax increases that economists say would plunge the country immediately into recession again. Pretty much all tax bills would rise, but especially for those who own stocks or other investments. It takes Congressional action to prevent this “fiscal cliff,” and inaction would be an unprecedented failure of government. Yet confidence in Congress to do the right thing does not run high.

For the most part, these issues were known obstacles to share price growth a year ago too, and it’s a little unclear how we got to these heights so quickly in the first place. Perhaps it’s because many investors believe that U.S. corporations, a lot of which are quite cash-heavy, are well set to soar once these issues go away. It’s the timing of those resolutions that matter. Just ask one of those bearish hedge fund managers.

Dee Gill is an editor for YCharts Pro which includes the new YCharts Pro Platinum service for professional investors.



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