Apr 23, 2011

Stock Market Crash Nearing?: One Way to Know the Top is Here

By Andrew Mickey, Q1 Publishing

The unending stock market rally may have just got its next boost.

Following the first big week of earnings season - where the markets signaled it would once again easily leap the quarterly earnings hurdle - the Dow just a few days from a three-year high.

The run-up has a lot of investors more fearful than they have been in a long time. But despite the rally’s strength, there is one long-time indicator that says “the top” is still not in.

3 Stages of a Bear Market Rally

Just over two years ago, when the current rally first got underway, we tried not to dismiss it too quickly.

History shows dismissing a major market move presents a huge missed opportunity. And given how deeply the markets were crushed in 2008, the upside potential of a rally was enormous.

That’s why we let history be our guide. And history said there are three stages to every bear market rally:

Stage 1: “It's all over” – the stage where most investors refuse to admit the markets are truly rallying. They often write it off as a short-term anomaly that cannot and will not last.

Stage 2: Popular Declaration of “Bear Market Rally” – the stage when more and more stock market bears throw in the towel. They capitulate and buy in. But they are always seeing the next hurdle as a reason to sell too soon.

Stage 3: “All clear! Get in before it's too late.” - the stage where “panic buying” sets in. Investors buy aggressively and indiscriminately because they’ve missed out on so much and painfully watched the rally go longer and higher than they ever believed. In this stage and typically take big risks for relatively small returns.

At the time when we broke down the stages of bear market rallies, we surmised the rally would be like many others and last longer and go higher than most investors could reasonably foresee at the time.

We proposed the Dow 12,000 and the rally could last as long as a year.

The rally, however, exceeded even our “extremely optimistic” (at the time) projections.

Now that the rally is in the later innings, we notice a trend that shows it still hasn’t fully run its course.

Get Worried When This Happens

Yesterday, polling firm Gallup released the results of its latest survey. One result was very surprising.

Gallup learned the percentage of U.S. residents owning stocks has fallen to the lowest point in over a decade.

The chart below shows the percentage of American’s who own stock relative to the S&P 500:

The chart shows a strong correlation between the breadth of stock ownership and market peaks.

At the height of the tech and housing bubbles, American participation in stocks was well over 60%.

At the bottom of the credit crunch the bear market sent a lot of investors scrambling away from stocks. The percentage of Americans owning stocks fell from a 2007/Dow 14,000 high of 65% to a low of 57% at near the bottom.

The surprising trend is that today the number of Americans owning stock has fallen to 54% - the lowest point in the past 12 years and even lower than the bottom when millions of stockholders threw in the towel.

There are likely a many reasons for this decline. High unemployment has surely forced a few potential stock buyers to reduce risk and keep plenty of cash on hand for living expenses. Americans, as a whole, continue to pay down debt which would leave less cash available for stocks. And the pain many investors felt in 2008 won’t be forgotten for a long time.

All of these factors have combined to sharply reduce the percentage of Americans who own stocks.

This should give bears and the crowd that has missed out on the entire rally even more caution.

There are still plenty of new investors that haven’t been sucked into the current rally. And every bubble top has been associated with a large percentage of Americans participating in it.

Keep it Simple: Risk and Reward

Does this mean we should jump headlong into stocks?

The short answer is a simple “No.”

With stocks so richly valued, the risk/reward has completely turned upside down. Right now it’s far riskier to buy in hoping to squeeze out another 5% or 10% gains while risking facing a sharp 20% to 30% correction to a much more reasonable valuation.

Going “all in” on a market wide bet just doesn’t make any sense. However, there will continue to be opportunities presented in this market where the American populace will pile into in a big way.

There are new trends emerging and in the next few Prosperity Dispatches we’ll look at those new trends that will attract a lot of investment dollars in the months and years ahead.

Good investing,

Andrew Mickey
Chief Investment Strategist, Q1 Publishing