The Red Flag I’m Seeing in Stocks Right Now

In my previous article, I talked about the vulnerability of stocks at this time, a disappointing economy, and what will likely be disappointing earnings. 

On the weekend, I was thinking back to 2000, when the stock market came crashing down after a sizzling but unwarranted run-up in technology stocks and initial public offerings (IPOs). It wasn’t pretty, and while I don’t believe the stock market is priming for another major sell-off right now, I’m still nervous. 

The DOW recovered to 17,000 on Monday, but if it fails to hold again, I would be wary. The failure of the S&P 500 to test 2,000 despite coming so close is also a red flag, based on my technical analysis. 

Yet unlike 14 years ago, the current bull stock market, which is in its fifth year and looking weary, has largely been driven by the easy money the Federal Reserve has been pumping into the economy. The reality is that this third round of quantitative easing (QE3) will likely be dissolved by October and interest rates will be heading higher by mid-2015. As I said the other day, this will have a negative impact on the stock market. 

In addition, the rising flow of capital into the stock market by retail investors is also a red flag that has generally been followed by selling in the past. 

What you have are investors who have sat on the sidelines, waiting for a major stock market correction that really hasn’t materialized in five years. This group sees people making money in the stock market and decides they need to jump in with little regard as to where stocks are right now. This is a dangerous strategy, and I don’t suggest it for anyone. If you are looking to enter the stock market, I’d suggest you take the low-key wait-and-see approach. 

According to an article I read in Bloomberg, approximately $100 billion flowed into mutual funds and exchange-traded funds (ETFs) over the past year, up 10-fold over the previous 12 months. (Source: Wang, L., “Individuals Pile Into Stocks as Pros Say Bull Is Spent,” Yahoo! Finance web site, July 14, 2014.) When retail investors start to chase gains when the stock market is high, you have to pause and step back. Remember: the same massive cash infusion occurred prior to the carnage in early 2000. 

While the stock market could surprise us, as has been the case over the last few years and especially in 2013, this is something you have to monitor and be aware of. The last thing you want is to be sideswiped by a stock market correction and watch your capital vaporize. 

Yale professor and Nobel Prize–winner Robert Shiller suggests stocks are vulnerable based on a higher “cyclically adjusted price-to-earnings ratio,” or CAPE. In the other times when the CAPE was as high as it is now, we saw major corrections—1929, 2000, and 2007. (Source: Task, A., “‘It looks like a peak’: Robert Shiller’s CAPE is waving the caution flag,” Yahoo! Finance web site, June 25, 2014.) 

In my previous article, I talked about writing covered call options to generate some premium income should the stock market stall over the summer months. But to protect yourself from a full-scale sell-off, you also need to take some profits off the table on your big winners, especially if they are technology and growth stocks, which are the most vulnerable at this time. You may also want to consider buying some put options on stocks, sectors, and/or key stock indices as a protective hedge