Are the Markets Staring at a Massive Plunge?

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Is the Dow Jones Industrial Average past its peak after a record run?

After a steep climb to the top of the hill, major U.S. stock indexes, including the Dow Jones Industrial Average (NYSEARCA:DIA) and the S&P 500 (NYSEARCA:SPY), have recently reached record highs. Will the climb continue or is the stock market at the top of the roller coaster and about to take a historic plunge?

More and more signs point to a plunge for the Dow Jones Industrial Average and major indexes rather than a continued climb. Here’s why:

1. Excessively bullish sentiment: The Investment Company Institute reports that inflows to mutual funds from retail investors are running at high levels, with $1.05 billion coming in the week ending February 27 and a whopping $5.02 billion during the week of March 20 as mom and pop investors scramble to buy stocks after missing most of the recent rally.

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The Investment Company Institute also reports that the total assets of all stock-based mutual funds climbed from $5.93 trillion in December of 2012 to $6.29 trillion in February of 2013 — and that was before the record-setting highs.

2. Deteriorating economic fundamentals: The impact of the budget sequester is now being illustrated by the recent jump in unemployment claims, as well as the disappointing payrolls reports from ADP and — most recently — the closely-watched non-farm payrolls report from the U.S. Bureau of Labor Statistics on April 5, which was an unmitigated disaster.

The Institute for Supply Management’s March 2013 reading declined 2.9 percent from February’s 54.2 for a reading of 51.3 during March. The ISM also reported that its March Non-Manufacturing Index fell as well, missing expectations, to join previous disappointments in recent PMI reports…

3. Contrarian bullishness: Dr. Alan Greenspan, often called the “ultimate contrarian indicator” by many analysts, appeared on CNBC on March 15 to say that he would not use the term “irrational exuberance” to describe the current level of investor enthusiasm. Dr. Greenspan described stocks as “significantly undervalued”. This remark set off alarm bells with many commentators and investors and those bells continued as Meredith Whitney chimed in on CNBC, saying, “I have not been this constructive and bullish on US equities in my career.” Such “uber bullishness” has oftentimes proven to be a good sell signal for the Dow Jones Industrial Average and other major stock indexes.

4. Sell in May and Go Away:  Regular readers of the StockTraders Almanac are familiar with the maxim “Sell in May and go away”. This doctrine is based on the fact that the period between October and May is the time of year when most gains are made in the stock market, with the five-month period of May through September being negative or flat.As we move into April’s showers, May’s “flowers” are just days away.

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5. Bond market warnings: The bond market has not been behaving in a way that would confirm the recent rally in the Dow Jones Industrial Average and other major U.S. stock indexes.

chart courtesy of StockCharts.com

In this chart of the S&P 500 and 10-Year Treasury Bond yield (NYSEARCA:IEF) we can see how the two have decoupled as bond yields have been dropping while the stock market has been climbing. 

This is not the normal configuration of these two indexes and so it’s likely that one of them is wrong and will have to correct to eliminate this divergence.The bond market is usually considered to be “smarter” than the stock market and so this would point to the possibility of a significant correction ahead for the S&P 500.

Bottom line: Overall, current conditions bring us a combination of deteriorating macroeconomic fundamentals, contrarian indicators, negative technical data as well as the time-honored, seasonal admonition to “sell in May and go away.” Added together, it’s easy to conclude that major U.S. indexes like the Dow and S&P 500 may have, indeed, reached the top of the roller coaster and are about to take a significant plunge.

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John Nyaradi is the author of The ETF Investing Premium Newsletter.

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