The chart says it all… E-mini S&P 500 futures are encountering big resistance at the top of the five-year uptrend channel that has contained prices since the 2008 crash and appear poised for a correction that we believe could take prices down at least 10% in the next four months. Stocks have corrected sharply each and every time they’ve run into this up-sloping line with the biggest correction occurring during the summer of 2011 following a 26-month rally. December will mark the 26th month of this rally, putting the current bull market firmly in the “long in the tooth” category.

The S&P is up 31.25% in just the past twelve months, outpacing both earnings and economic growth. And while stocks can and often do rally in a weak economy, it pays to remember that gains like this are not normal – not even during good times. Bernie Madoff got caught because someone eventually figured out that much smaller gains of 10% weren’t sustainable – at least not on a consistent basis. If 10% is too much to expect, 31.25% is asking for the moon.

Untitled

Will the stock market repeat its incredible 2013 performance next year? It is certainly possible but the odds are against it. The market has already priced in an improving economy and may have effectively stolen potential performance from 2014. With another budget fight and the threat of yet one more government shutdown looming after the Holidays (The two sides are not even talking yet!), now may be the time to start thinking about protecting some of the gains in the stock portion of our portfolios.

Three More Reasons to Expect a Correction

1)   Stocks are going up while earnings expectations are going down. (See chart below.) PE ratios are expanding.

stocks

1)   New stock and bond issuance is exploding. $51 billion in new Initial Public Offerings (IPOs) have already taken place this year — the most since the $63 billion issued in 2000 right before the dot com crash. Not only does this increase the supply of stock, it also sends a potentially ominous message: the “smart money” is selling.

 

2)   Joe and Jane Sixpack are getting back into the market. After spending the last 5 years on the sidelines, individual investors are starting to shift assets back into stocks. This may be the most disturbing signal of all. On the graph below, notice the last time individual investors were so interested in buying stock. It was right before the last big correction during the summer of 2011.

allaboard

What to Do Now

We are calling for a correction, not a meltdown so we are not recommending dumping all of your equities. However this may be a good time to consider a hedge or, if you are of more of a speculative nature, a low cost short position looking to take advantage of a the growing potential for correction over the next 4 months.

We are currently recommending a spread play in the E-Mini S&P 500 options with a maximum risk of $800 plus transaction costs and a gross profit potential of $5,000 should the March E-Mini futures hit our 1600 (10% correction) target prior to mid-March. Each “spread” covers an index value of $85,000.

RMB Group trading customers interested in this strategy either as a hedge or a speculative play should contact their brokers for a specific recommendation. If you are not an RMB Trading Customer, give us a call at 800-345-7026 (toll free) or 312-373-4970 (direct) and we’d be happy to go over this strategy with you. You can also e-mail suerutsen@rmbgroup.com. Put the words “stock hedge” in the subject line.

 

The RMB Group

222 South Riverside Plaza, Suite 900, Chicago, IL 60606