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Wednesday, 7 April 2010

Dow 11,000 - How Much Upside is Left?

Simon Maierhofer

With the Dow briefly poking above 11,000, we ask ourselves if the momentum will carry stocks yet higher, or if an investment in stocks will turn out to be the proverbial hot potato.

Of course, Wall Street and the financial media tend to find plenty of reasons to rationalize why the economy is strong and higher prices are on the horizon. But Wall Street is always recommending to buy and advocating higher prices, so it behooves us to dig a little deeper.

2000, 2007 and 2010 - Today is different, right?

Today's 'bull market' is so different compared to what we saw in 2000 and 2007 and yet it is so similar. No matter what causes stock prices to rise, investors get excited. The higher the prices, the more excited they get.

Imagine you are auctioning off one of your old putters. The initial bid price is $100. There are no bids until finally one bidder gets the snowball rolling. Dozens of bids later, your putter sells for $200, twice the amount you were hoping to get.

Let's buy high and sell low

Your golf bag is now one putter lighter but your wallet $200 richer. Of course you don't worry about that, but the new owner should ask the following: 1) Why didn't anyone buy the putter at $100? 2) How much could I sell the putter for, is it worth $200?

Of course this is a simple illustration of a complex process, but take the putter, replace it with stocks and ask yourself: Why didn't anyone want to buy stocks at Dow (NYSEArca: DIA - News) 7,000? 2) If I own stocks today, how much can I get for them tomorrow?

The ugly truth is that only one out of five investors was bullish and wanted to own stocks in March 2009 when the Dow Jones (DJI: ^DJI) traded at 7,000 and below. In fact, on March 9, 2009, the Wall Street Journal featured the following article: Dow 5,000? - There's a Case for it'

At the same time, Goldman Sachs slashed earnings growth for the S&P 500 (SNP: ^GSPC) by 37%. When things were bad, they were expected to get worse. Exactly at that time, the ETF Profit Strategy Newsletter issued a Trend Change Alert and recommended to buy long and leveraged long ETFs like the Financial Select Sector SPDRs (NYSEArca: XLF - News) and Direxion Daily Financial Bull 3x Shares (NYSEArca: FAS - News).

But why buy at Dow 7,000 if you can buy at Dow 10,000? Why buy a putter at $100 if you can pay $200 for it. When everyone buys, it seems to make us feel secure that prices will continue to go up and makes us feel better about owning something, even if we paid too much.

Who wants to get burned twice?

Looking back a few years, we notice that buying high has 'worked' before. Tech stocks (NYSEArca: XLK - News) became more attractive the higher they traded. Leading up to its top, the Nasdaq (Nasdaq: ^IXIC) more than doubled in less than a year.

I remember one sunny San Diego morning in January 2000, when I visited the local Jack White office in La Jolla, CA (Jack White was purchased by TD Waterhouse, today it's TD Ameritrade), there was a line of 'wanna-be investors,' including grandmas and mothers with children, waiting to open a brokerage account. That was my clue to sell.

Fortunately, the 2000 tech-meltdown was buffered by double-digit gains in real estate. In fact, real estate became the next infallible investment. Once a basic need, real estate became an investment.

Owning real estate (NYSEArca: ICF - News) was viewed to be an absolute necessity to achieving retirement. As it turned out, buying real estate was a sure way of mortgaging your retirement.

No buffer

In 2000, rising property prices buffered plummeting tech stocks. In 2005 and 2006, stocks (NYSEArca: TMW - News) provided the buffer for real estate losses. In 2008, commodities (NYSEArca: GSG - News) provided a slight cushion for stock and real estate losses and another painful reminder of how bubbles work.

Oil (NYSEArca: USO - News) spiked briefly above $140/barrel before barreling to below $35, less than a year later. Almost two years ago, when gas (NYSEArca: UGA - News) was around $5/gallon, everyone expected gas prices to keep moving higher, they didn't.

Notice how the buffer became less significant with time. Real estate gains in 2000 were huge. Stock gains in 2005 were helpful. Commodity gains in 2008 were nearly insignificant.

The question is which asset class could buffer a stock market decline today? I don't see one.

Misconceptions about oil, the US dollar and stocks

Two years ago, rising oil prices were viewed as a sure way to depress stock prices and the economy. Over the past year, oil prices have steadily risen but nobody cares. Rising oil prices, along with higher unemployment and more foreclosures don't seem to bother stock prices either. Large oil companies (NYSEArca: XLE - News) and the average Joe are not usually happy at the same time. This time is different, right?

From March to December 2009, the US dollar was caught up in a downward spiral. The US Dollar Index tumbled from 90 to 74. Several nations even suggested stripping the US dollar of its global reserve currency status.

At the same time, on November 13, 2009, the ETF Profit Strategy Newsletter wrote the following: 'The U.S. Dollar Index has been bouncing around 75 for over a month now and seems to either have found or be close to a bottom.' The newsletter issued a buy signal for the PowerShares DB US Dollar Bullish ETF (NYSEArca: UUP - News).

The chart above illustrated the strong negative correlation between the US dollar and stocks up until December. Since then, stocks and the buck have rallied together. This is unusual and according to Wall Street's conventional wisdom not sustainable. But this time it's different.

About perception and valuation

Tune out the noise, and you'll see that aside from others buying stocks, there are few compelling reasons to buy into the market at current levels.

Of course, demand is what drives stocks and as long as demand is there, prices will go up. But what drives demand, perception and valuation?

Your old putter fetched $200 because someone perceived it to be worth $200 simply because others were bidding alongside with him. The proud, new owner of the putter doesn't know that you paid only $100 for the putter.

The more golfers find out about the putter's actual value, the fewer buyers there will be. The valuation of the putter has now changed the perception of potential buyers. The ultimate result is that the price will drop way below $200.

The key question: what are stocks really worth because we know that's eventually what stocks will trade for?

According to Professor Shiller, the S&P (NYSEArca: SPY - News) is 30% overvalued. According to ETFguide's research, the extent of overvaluation is even worse.

Regardless of which analysis you chose, stocks will eventually turn into a hot potato. Will you get burned?

The ETF Profit Strategy Newsletter includes a detailed short, mid and long-term forecast based on common sense indicators and out of the box thinking.

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