4 Trends You Need to Know About This Bull Market

As the markets reach new highs, investors have begun to express caution instead of celebration.

Since Nov. 15, 2012, the S&P 500 has risen an impressive 15%. That works out to be a 45% annualizedgain . And the whole time, a significant number of investors have remained dubious, citing ample reasons why themarket should be moving lower -- not higher. And as the market has climbed this "wall of worry ," even the most ardently pessimistic bears have thrown up their hands in dismay.

My colleague Adam Fischbaum touched on some concerns in this column .

To be sure, the fourth-quarterearnings season held few negative surprises, and first-quarter results are likely to be at least in line with forecasts. Plus, the increasingly robust employment picture indicates the U.S.economy almost surelywill avoid arecession in 2013, even with the boulders that Washington policy makers throw in its path.

Still, a host of otherfactors leaves the bears unconvinced this rally has staying power. Watch these factors closely and be prepared to take profits before any modest pullback morphs into a major rout.

Here are the unusual factors driving the current market.

Massiveshort covering
According to Bloomberg News, only 5.6% of allshares are now held in short accounts, down from 12% five years ago. That's a 53% drop, which is the lowest level in history. In fact, much of the drop has come in just the past four months.

Short sellers often move as a herd. When they realize their colleagues' resolve is weakening, as evidenced bybacking away from short positions, they also capitulate and cover their positions. After all, it's unwise to stand pat and watch heavily shortedstocks rally. And when short sellers seek to cover their positions, they must buy back shares they borrowed, which creates a form of buying pressure for the market.

In a study conducted by the BespokeInvestment Group, the following stocks had a short position equivalent to at least 25% of theirshares outstanding as the year began, but short covering has pushed them up sharply.

Short Interest as a % ofFloat (SIPF)

At some point, perhaps soon, this phase of short covering may come to an end, removing one of the sources of fuel for this rally. And paradoxically, it's often wise to seek out short ideas once short-selling is exhausted. That's because ashort squeeze -- such as in the stocks noted above -- can lead to renewed selling pressure once the shorts are emboldened to try their hand again.

Surgingmargin debt
Few investors recall it now, but margin debt was one of the biggest factors behind the huge rise and fall of dot-com stocks. Fevered investors borrowed from theirbrokers in a rush to buy stocks in 1999 and 2000. Yet by the spring of 2000, those same brokers were calling their clients asking for theirmoney back, as a falling market shrank theequity balances to levels that made the margin loans look too big. As investors sold off their falling dot-com stocks, the market moved lower, triggering even more margin calls and creating one of the ugliest years ininvesting history.

Investors are at it again, taking on debt just to buy rising stocks. They are pouringcash into their accounts in order to chase this rally higher, as they did in 1998 and 1999. Back in August,gross margin debt (prior to the reflection of offsetting cash) stood at $288.6 billion.

Here's what has happened since.

Surging Market Debt ($billions)

This $80 billion spike in gross margin debt in just six months won't be a problem if the market holds its ground in coming weeks and months. And indeed, many investors have built in a cash cushion to guard against market pullbacks. But it's those investors who are using margin in an especially aggressive fashion that createmarket risk . Major market pullbacks would force them into selling, which creates further market weakness. As I wrote in October, "Even if just 20% or 30% of margin accounts get amargin call from brokers, then we're talking about tens of billions in selling pressure into an already weak market. This can push the market down to trigger the nextwave of margin calls."

A tiredbull ?
Abull market is a gain of at least 20% without a 20% pullback in its midst, and there have been two since the dot-com meltdown in 2000. The first one began in October 2002, lasted 67 months and generated a 101% rally in the S&P 500. The next -- and current -- bull market began in March 2009, and has delivered a 128% gain after only 48 months. There have been only two bull markets since 1956 that have delivered greatergains than the current bull.

In a study conducted by Merrill Lynch, the average bull market has lasted 30.7 months and delivered a 104% gain. Sure, this bull can continue running, but historically speaking, we're living on borrowed time.

Profits are not as impressive as you might think
Analysts repeatedly have slashed their near-termprofit forecasts, only to find companies exceeding the newly lowered set of expectations. That has given the impression of better-than-expected profits, but you'll see something different if you take a wider view.

At the start of 2012, all of the companies in the S&P 500 were expected to earn roughly $118 a share in 2013. Yet with each passing quarter, analysts have been taking an ever-dimmer view. Now, the aggregated profit forecast for the S&P 500 in 2013 is just $108 a share. If Washington's ongoing circus continues to vex the U.S. economy, we might be looking at S&P 500earnings per share ( EPS ) of just $100 this year. That's the view of Morgan Stanley strategists -- one that may soon be shared by others.

Action to Take --> With the always-present possibility of a market reversal, keep a close eye on the daily closes of the S&P 500, as they can provide insight. A few days of market drops may seem innocuous, but can signal a new trend.

For example, from Oct. 5, 1987, until Oct. 16, 1987, the S&P 500 lost roughly 1% in every session. That last date marked the fourth straight days of losses, and investors had seen enough. In the following session on Oct. 19, 1987, the S&P 500 fell 20% in just one day. So don't take signs of profit-taking too lightly.

Still, the major indexes are nicely above their 50-, 100- and 200-day moving averages. Yet many technical analysts keep an eye on the50-day moving average chart as a sign that the bull is getting tired, and abear may be on the prowl. For the S&P 500, the 50-day moving average stands at 1,495, roughly 55 points, or 3% below current levels. If you're nervous about when to take profits, keep an eye on that number.

A much simpler way to avoid getting crushed by a market rout is through the use of stop-loss limit orders. As traders like to say in a raging bull market, "keep your stops tight."

Let's use an example. If you invested in Netflix (Nasdaq: NFLX) last fall, you've seen its shares soar by about 200% to $180 a share. Can Netflix move even higher? Perhaps. Can Netflix be hit by massive profit-taking? Surely.

That makes this a good time to place a stop-losslimit order for Netflix at about $170. If shares start to weaken, the crowd could trigger even bigger selling (just as we've seen with Apple during the past fewquarters ). Remember, it's not what you think astock is worth, but what the crowd thinks it's worth. And if the crowd starts to change its mind, you can't afford to stick around.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.


Authors: TSX Today

What is S&P/TSX Composite Index?

S&P/TSX Composite Index

The TSX stock exchange defines an index as a statistical measure of the state of the stock market, based on the performance of certain stocks. The performance of the index is typically viewed as a broad indicator of the direction of the economy. Originally known as the TSE 300 the composite index was created in 1977, with a base level of 1000 as of 1975. Through the years the index consisted of a sample of 300 companies, though the companies that comprised the index varied from year to year. Stocks were dropped when they no longer met exchange requirements for size and liquidity.

Effective May 1st, 2002 the index has been managed by Standard & Poor's Corp. of New York. The name was changed from the TSE 300 to the S&P/TSX Composite Index. Along with the S&P branding came new rules. Tougher criteria for meeting size and liquidity standards were imposed and there is now no fixed number of companies in the index. Since May 2002 the number of companies has dropped from 300 to 212 as of November of 2003.

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