Here’s Another Danger Sign That Stock Investors Will Ignore

In my Money and Markets column on Oct. 23, as U.S. stocks were rising to a record high, I warned that a big drop is inevitable.

The main reason, I argued, is that equities are wildly overvalued because the Federal Reserve has created a bubble by plowing almost $4 trillion into the investing markets.

Here’s another sign of danger: The chart below shows that the margin debt on the New York Stock Exchange is approaching a level that often coincides with a correction in the stock market.

Click for larger version

Are we there yet?

Probably not. That’s because investor sentiment, as measured by Investor Intelligence, is bullish. Investment-adviser bulls represent more than 52 percent of the total, with bears just below 28 percent and those who are neutral at 20 percent. Normal conditions are considered to be 45 percent bulls, 35 percent bears and 20 percent neutral.

Most investors have convinced themselves that this time is different, that despite clear signs of an overbought, exhausted market, stocks can keep rising. The bulls claim that what’s different this time is complete faith in the Federal Reserve’s policy of quantitative easing, its $85 billion a month in bond purchases that artificially lower interest rates.

Their position can be essentially reduced to a claim that QE makes stocks go up because “it just does.” But that’s not valid. Aggressive periods of easing by the Fed couldn’t prevent — and may have even caused — the 2000 bust or the 2008 collapse.

But as fund manager John Hussman says: “QE is novel, and, like the Internet bubble, novelty feeds imagination. And most of what investors believe about QE is imaginative.”

Ray Dalio, the founder of hedge fund Bridgewater Associates, recently observed: “The dilemma the Fed faces now is that the tools currently at its disposal are pretty much used up. We think the question around the effectiveness of QE going forward is the big deal. In other words, we’re not worried about whether the Fed is going to hit or release the gas pedal, we’re worried about whether there’s much gas left in the tank and what will happen if there isn’t.”

The recent strength of the stock market is part of the reason investors keep holding on even as indicators such as excessive margin debt tell them to do otherwise. Unfortunately, beliefs are what they are, and are only as changeable as the minds that hold them.

It’s similar to the nearly religious belief in the dot-com boom and the sub-prime bubble, as well as numerous other bubbles throughout history. People are going to believe what they believe until reality catches up with them in a most unpleasant way.

What fund manager would want to forgo the markets’ substantial gains this year? He’d likely be fired if he did.

The problem with markets as they reach their peaks is that they force investors to decide whether to look like an idiot before the peak (if they move to the sidelines), or an idiot after the peak (if they stay invested). That’s because no one can precisely call the top, and most of the traditional signals that have been useful for that purpose have been telling investors to pull back on their stock holdings since late 2011.

Which fund manager or investment adviser would want to forgo the benchmark S&P 500 Index’s 13 percent gain in 2012 and 27 percent jump this year? He’d probably be fired if he did.

Is this time different? I doubt it. Risk is everywhere. Be careful. And if you choose to invest, consider buying some shares of large dividend-paying multinational companies. To see one company I like, please go to Money and Markets’ Facebook page — and make sure to tell me your picks.

Best wishes,

Bill

Bill Hall is the editor of the Safe Money Report. He is a Certified Public Accountant (CPA), Chartered Financial Analyst (CFA) and Certified Financial Planner (CFP). Besides his editorial duties with Weiss Research, Bill is the managing director of Plimsoll Mark Capital, a firm that provides financial, tax and investment advice to wealthy families all over the world.