10/30/13 3:08 PM – Stock Market is Very Extended

It’s been a great year for stocks and the 3rd in the last 4 years. That is particularly true for U.S. stocks and especially growth stocks and small stocks. The European markets have done well, too and the emerging markets have come on after a dismal start to 2013.

However, I see some real warning signs. First, there is a lot of complacency in options and sentiment ratios right now. The volatility index is also very low and starting to stir. While those can continue for a while, they are contrary indicators.

More importantly, the S&P 500 is now 32% above its 200-day moving average. Only on 5 prior occasions in the last 50 years has the market been so far above its long-term moving average, a sign of short to medium term over-exuberance. Here are the numbers:

1983 30% fell 12%
1987 59% fell 32%
1989 31% fell 12%
1998 62% fell 19%
1999 45% fell 40%

Each of the 5 previous times the market took a plunge shortly thereafter. Since we are currently around the figures in 1983 and 1989, you would figure that we are in for a similar 12% drop, give or take. However, a couple things are different this time.

First, since the low in 2009, the market is up 100% in 4.5 years. That compares to 50% off the lows in 1983 and ’89. Second, the market is largely up on unprecedented monetary stimulus, not a strong economy. The appointment of Fed. Chairwoman Janet Yellen probably continues an extended time of super-low interest rates and Fed bond-buying, so that stimulus is likely to continue. I don’t see the economy heating up anytime soon.

I’m not calling for a crash, or telling you to sell stocks right now. I am merely pointing out that a 10-15% correction is likely in our future sometime in the next few weeks or months. If we continue higher at the present pace, we will all enjoy that a great deal, but we also run the danger of seeing a much larger subsequent drop like 1987, 1998 or 1999, but that is not the case yet.

In the meantime, enjoy the gains but don’t get too complacent about risk.