Stocks Ready for a Setback?

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While US economic data over the last two months have shown signs of improvement, there are a number of factors that suggest that current equity prices may have become a bit rich and that the market is ripe for a setback. US economic data showed considerable improvement in late 2010, and that was instrumental in driving the S&P 500 up more than 11% off the November lows. Meanwhile, the optimism seemed to feed on itself and prompt several large Wall Street banks to raise their 2011 US growth estimates, as well as their upside price targets for the S&P 500, with some estimates calling for equities to appreciate an additional 20% in 2011. There appear to be a number of factors behind the positive trend in economic readings, including massive and unprecedented government interventions. During the 4th quarter alone, the US Fed embarked on a second round of quantitative easing worth $600 billion, and Washington approved the extension of the Bush era tax cuts, worth an estimated $900 billion. Easy monetary conditions in the face of improving growth prospects have reinvigorated inflationary fears, as evidenced by the resurgence in a number of physical commodity markets to multi-year highs. While there remain concerns over how to pay for all of these stimulative measures, it appears that the prospect of limitless US government spending, along with ideas that Washington will do everything in its power to engineer a financial recovery, has escalated inflation fears as well as risk taking.

However, there are indications that growth expectations are moderating, which could limit the outlook in the US and reduce equity market valuations. Many emerging market nations like China and India have implemented rounds of monetary tightening in an attempt to rein in growth and inflation. While some of these maneuvers have already been factored into the market, the threat of reduced growth in these nations could have drastic effects in the US. Meanwhile, the growth in US debt is confronting Congress with the issue of raising the US debt ceiling by the end Q1 2011. With new leadership in the Senate, any increase in the US credit line is likely going to come with reductions in government spending, which raises additional concerns over reduced US growth. Some states have begun to address the spending shortfall, with Illinois hiking tax rates that are likely to slow output by $6.5 billion this year and California discussing spending cuts in the neighborhood of $12 billion.

Given the economic uncertainties facing the equity market today, a number of sentiment readings appear overextended and hint at a near term correction at a minimum. A recent survey from Investor Intelligence showed the percentage of bullish market participants climbed to 58.8% in December, which corresponded to the equity market peak in 2007. It almost seems that markets has factored in a remedy to all US economic ailments and has become extremely complacent, evidenced by an extremely low CBOE VIX Index that bounced along the bottom of the range of the last seven years. Finally, the market is technically overbought territory, with a number of momentum indicators that have failed to confirm the higher index pricing.

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