The Last Three Times the Market Flashed This Signal Stocks Fell off a Cliff

The Last Three Times the Market Flashed This Signal Stocks Fell off a Cliff

  • The Last Three Times the Market Flashed This Signal Stocks Fell off a Cliff
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Last week, investors got more happy news. The Fed announced it would keep printing $85 billion a month to buy Treasury and agency mortgage-backed bonds.

By printing money and buying bonds (aka monetizing debt), the Fed is going to keep shooing investors out of bonds and into stocks... funding government spending... and pushing up inflation rates to make outstanding debt easier to pay back.

And not only that, but it's also going to keep doing so until the unemployment rate becomes "acceptable" again – in other words, as far as the eye can see. The one thing that has not responded to the Fed's credit and cash deluge is the unemployment rate, which is still at 7.7%.

Against this backdrop, stocks have been rallying. And the big question everyone is asking is: Should they join the party?

Frankly, this is a terrible question. I can virtually guarantee that if this is the way you think about investing, you're going to have a miserable time in the markets over the long run.

Here's how my friend and legendary resource investor Rick Rule put it recently (with my own emphasis added):

Speculating on the events that are certain or almost certain to occur is almost always more profitable than gambling on a long shot, unlikely occurrence. Make investments based on unlikely scenarios only when the potential risks and rewards are disproportionately in your own favor and you can afford the loss that you may incur.

This is the only question that matters: Are the potential risk and rewards disproportionally in your favor?

Usually that happens when you can buy a stock... or other investment asset... at a price that is below its intrinsic value. It certainly doesn't happen when you rush out and buy something because: (a) everyone else is buying or (b) because you think you can find a "greater fool" to buy something that is already overvalued.

So are the risks and rewards of following the crowd into U.S. stocks disproportionately in your favor right now?

To answer that question, let me share with you an observation made by bearish fund manager John Hussman recently. Then you can decide for yourself.

[Two weeks ago], Investors Intelligence reported that the percentage of bearish investment advisors has declined to just 18.8%. The last time bearish sentiment was below 20%, at a four-year market high and a Shiller P/E above 18 (S&P 500 divided by the 10-year average of inflation-adjusted earnings – the present multiple is 23) was for two weeks in May 2007 with the S&P 500 at about 1,525.

The next instance before that was two weeks in August 1987 (bearish sentiment never dipped much below 27 approaching the 2000 peak except for a reading of 22.6 in April 1998, just before the Asian crisis). The next instance before that was for three weeks of a five-week span in December 1972 and January 1973, which was immediately followed by a 50% market plunge.

Now, I realize this isn't the kind of analysis you'll find on CNN Money or CNBC. But it's vitally important because it shows you what has happened in the past when we have had the same kind of market setup we have today.

Here's a chart of what happened after the most recent instance of this same setup – in May 2007.

S&P 500 2007-2009
View Larger Image

I am not saying that stocks are destined to plunge again. They may or they may not. I'm simply pointing out that the kind of sentiment readings we're seeing today mixed with the kind of valuations we're seeing today have not been a recipe for profits in the past.

The risks and rewards, in other words, have NOT been disproportionately in investors' favor.

Forewarned is forearmed, as they say.

Good investing,

Chris Hunter

Chris


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