When Cash Is King for Stock Market Investors

The optimism on the key stock indices is increasing as the fundamentals that suggest the rally will go on continue to deteriorate. Investors beware; this disparity doesn’t end well. The possible upside gains look to be very small, and the downside risks are increasing.

To me, it feels like we are back in 2007 all over again—when key stock indices were making fresh highs and fundamentals across the board were tormented. Stock advisors were telling their clients to buy more. Irrationality was exuberant. I remember one celebrity stock advisor saying something along the lines of, “I know it doesn’t make sense buying overvalued stocks, but don’t worry; they are going to go higher.”

We see something similar now.

Investors are buying stocks. According to the data from Investment Company Institute, in January, investors purchased $23.9 billion worth of long-term stock mutual funds. This was the highest amount since January of 2013. (Source: “Historical Flow Data,” Investment Company Institute web site, last accessed March 7, 2014.)

As key stock indices are hitting their all-time highs, investor sentiment is turning bullish. According to the American Association of Individual Investors’ (AAII) Investor Sentiment Survey—which measures investors’ sentiment, be it bullish, bearish, or neutral—in the latest survey, which was on March 5, more than 40% of investors were bullish on the key stock indices. Bears were only 26.6%. (Source: “AAII Investor Sentiment Survey,” American Association of Individual Investors web site, last accessed March 7, 2014.)

This isn’t the only reason why 2014 looks like 2007.

Consider this: more and more companies are being listed on the key stock indices. According to Dealogic—a platform for investment banks—in the first two months of this year, 42 companies did initial public offerings (IPOs). The number of companies going public is similar to 2007. Investors are paying aggressive prices for the companies looking to raise money through the stock market. (Source: Demos, T., “Companies Rush to List Shares,” Wall Street Journal, March 6, 2014.)

Looking at the fundamentals, on the valuation front, the key stock indices are getting expensive. The current 12-month forward price-to-earning (P/E) ratio of the S&P 500 is 15.3. This ratio is above its five-year average of 13.1 and 10-year average of 13.9. (Source: “Earnings Insight,” FactSet, February 28, 2014.)

We continue to see companies on key stock indices warn about their first-quarter 2014 earnings. So far, 77 S&P 500 companies have issued negative guidance for their earnings in the first quarter. We expect this number to increase further.

This can’t be stressed enough: optimism is dangerous for the key stock indices. When it comes into play, investors end up making decisions that can be very irrational. Once reality kicks in, those who bought stocks tend to sell quickly to control their losses.

With all this, you have to keep something very important in mind: the irrationality we see on the key stock indices can continue on for a while. As it stands right now, investors’ hopes are too high. They may keep on buying and drive them a little higher yet, though I don’t think it will be for too long.

Investors at this point should be looking to preserve their capital. This is because a sell-off may be in the books sooner than many anticipate. Remember: cash is king when markets are down.