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Equity markets have rallied in recent months, even though many global economic indicators are pointing to a continued slowdown. So what's an investor to do?
I've written a playbook that both bears and bulls can use to help shape their investing outlook. But the final decision is up to you!
The bull's playbook
There are plenty of reasons to be bearish, but here's the bullish argument. The wall of worry is well-known (fiscal cliff, earnings weakness, global sluggish growth) and what is known is usually discounted.
Sentiment remains neutral to negative towards equities, which is a contrarian positive sign.
The American Association of Individual Investors, for example, is showing bullish sentiment at a 10-week low.
Mutual fund equity flows remain muted also suggesting that investors haven't even gone near the punch bowl never mind drinking blindly from it.
Economic data has turned decidedly positive versus expectations (with the Citigroup surprise index moving from a negative 65 in July to a positive 49 recently).
At these levels, expectations have been improving but not enough to expect a series of setbacks. Consumer confidence is at the highest level since 2007. Retail sales are relatively positive. Housing is bottoming. Stocks are cheap at 14 x earnings.
Liquidity is fiercely on the side of the bulls as the Fed, the ECB, the BOJ and to a lesser extent, the People's Bank of China are in the mood to be a wind at the back of asset valuations with plenty of money to go around.
There is an internal correction unfolding that might result in the averages going nowhere but providing plenty of fodder for individual sector or company opportunities to the upside.
For example, while a month ago almost 100% of tech stocks were trading above their 50-day moving average (dma), that number has collapsed to only 29%, suggesting a lot of damage in this sector is in the rear view mirror.
(Caveat, healthcare stocks using this 50 dma measure are extremely overbought).
The bear's playbook
Unfortunately, for the bulls, there are also plenty of bearish indicators out there. While earnings expectations have come down for the third quarter, they remain too optimistic for the fourth quarter and for 2013 (at +10% and +14%, respectively).
Manufacturing indicators are weak globally -- in most markets, sitting below the expansion/recession line of 50.
Profit margins are at levels considered unsustainable (i.e. costs and head counts have been reduced likely as much as they can be) and profit growth needs robust top line improvement -- which will be difficult in the slow growth world we currently live in.
Net long positions by hedge funds are at the highest level in a year.
The volatility index is showing complacency (the Fed is paying the put bill, why should traders?) The put:call ratio at 68:1 versus 135:1 in June is also indicating a lack of protective positioning in the market. The ratio of insider sellers to buyers is at a bearish 42:1.
The fiscal cliff is also a daunting barrier to growth next year, even if it is partially delayed. For example, many believe it is unlikely that all of the Bush tax cuts will be extended. And the issue of sequestration, a solution to the debt ceiling debate, will be hard for Congress to ignore (that represents some $607 billion US in automatic spending cuts next year).
And finally, the cycle is long in the tooth. The market has gone 93 sessions without a 5 percent correction. And at 3.6 years in length, this bull market is longer than 85 percent of all the bull markets since 1900 (according to work done by Ned Davis Research).
And those that were longer ended in tears in 1929, 1966 and 2000.