Is Buying Stocks Near All-Time Highs The Right Move?

By Chad Karnes

Wall Street analysts’ votes are in. The S&P 500 will end the year around 1,952. Put your money in an index fund, sit back, and take in 6% this year. Easy, right?

If only investing were so simple. History shows us time and time again that there are good times to invest and bad times too. How can we distinguish between the two?

No Bears Among ‘Em

According to a MarketWatch survey of those ten Wall Street banks, on the high side J.P. Morgan (JPM) sees the S&P at 2,075, a 12% potential gain by year end. On the low end of the estimates, Deutsche Bank (DB) sees 1,850, a flat return from the recent close.

Almost every analyst has a different end of the year target price, but one thing they all have in common – in a sure sign of groupthink - is the expectation of higher market in 2014.

The chart below shows one of those Wall Street Bank’s estimates through time. Goldman Sachs (GS) sees the S&P (SPY) at 1,900 by the end of the year and up to 2,100 by 2015 on the back of expected earnings growth.

(click to enlarge)

But looking at the chart, one thing stands out. Like most market participants, Goldman’s price targets have lagged the market’s movements. They were bullish at the market’s peak in 2007 and bearish at the market’s bottom in 2009.

When the market is rising such as the mid-2000s and today, the bank keeps raising its estimates. At the market’s peak at 1,575 in 2007, Goldman expected a continued advance over 1,650. Then, when the markets fell 20% the bank finally reflected reality in their estimates, lowering them in 2008 as the market moved lower.

When the markets bottomed in March 2009, Goldman thought prices were going to continue lower, which they of course didn’t. They played catch up with their estimates throughout all of 2009 as the market rallied.

This is shown by the black line on the graph as their estimates are more a reflection of the past and recency bias than they are of the future, especially at key market turning points.

A Market that is Complacent is one that is Dangerous

Analysts use a lot of different data and tools to come up with estimates, expectations, etc. to balance risk and return expectations. For instance, although the analysts quoted above all expect the markets (XIV) to end higher by next year, they also expect a “normal” 10% pullback at some point during the year, primarily because statistically it is long overdue.

If this is true, though, why not wait until that 10% pullback occurs before putting your money in the market? Wouldn't your reward potential would be over 16% instead of the 6% implied by their current estimates?

But when is the 10% pullback going to occur?

The chart below shows a tool I am using that other analysts likely aren’t or are choosing to ignore because it doesn’t support their conflicted interests of a rising market (SSO).

The chart below suggests conditions are ripe now for such a large pullback.

(click to enlarge)

In an article I wrote on 1/13 just before the market fell 6% last month entitled “Rough Road Ahead for an Overly Bullish Stock Market”, I pointed to the above chart along with a few other indicators that were warning of extreme complacency in the market.

As can be seen, even though it is now one month later and the market has already recovered the 6% pullback last month, complacency still sits near all-time highs as the number of investors actually expecting a market decline (measured by those who own put options compared to call options) still resides at six year lows.

The chart shows that when this ratio bottoms (historically around 80% the number of puts to the number of calls) the market (SDS) has its largest pullbacks. After all when everyone is bullish, there are fewer bulls left to continue to push the market higher as well as less people to sell to. Eventually bulls dry up and price must decline to attract them again.

When this ratio spikes higher, it has identified the better opportunities to go long. But right now this indicator suggests investors are far from that opportunity.

Are you still sure buying stocks at these levels is the right course?

Disclosure: No positions

Source: Is Buying Stocks Near All-Time Highs The Right Move?

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