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Now is the right time to turn cautious on the stock market
By: MarketWatch | May 2, 2019

Plenty of warning signs even as S&P 500, Nasdaq Composite reach new highs

Listen up, investors: It’s time to turn cautious on stocks.

Sentiment is getting rich — which sets the market up for a pullback in the contrarian sense. And while the S&P 500 index SPX, -0.55% and Nasdaq Composite COMP, -0.58% hit fresh records, fewer stocks are participating.

This combination — investor complacency plus narrowing market breadth — often shows up ahead of a nice pullback. Plus we are moving into the seasonally more volatile time of the year.

If we don’t see a pullback, at best we could see limited upside from here because all the good news may be priced in to the market, cautions Robert Doll, chief equity strategist and senior portfolio manager at Nuveen.

He’s not forecasting a bear market. But Doll doesn’t rule out a correction. “Could we give back half of what we gained this year? Of course we could.”

Investors are too focused on all the positives, he says, citing consensus views that a trade settlement is at hand, the Federal Reserve is on hold, and the economy is doing fine without sparking much inflation. “Life rarely goes as smoothly as all of that.”

Like anyone who’s been in the market awhile, Doll is quick to point out he’s not making a short-term market forecast. This would be futile, because no one can do that. “I’m just arguing the risk-reward is not as pretty as it was on Christmas Eve. We think conditions are starting to look a bit stretched.”

What to do now? Here’s my five-point prescription.

1. Get off margin. Now is not the time to own stocks with borrowed money. You don’t want to be leveraged into a pullback since this will amplify the pain. That will make you more likely to get emotional — and therefore make mistakes. Emotion is always the No. 1 enemy to successful investing.

2. Raise some cash to take advantage of better prices ahead. What’s right for you depends on your age, your risk tolerance and time horizon. But generally speaking, having about 20% to 30% of your stock portfolio in cash now may make sense. This will lessen the downside hit to your stock holdings in any pullback, and it will assure you have some buying power to pick up bargains. Since a lot of the good news is priced in, the chance you’ll miss out on upside by holding cash is diminished.

3. Get out of dubious trades. If you are in a stock that hasn’t been behaving “right” and you have doubts about it, now may be the time to exit. Mysteriously troubled stocks are often the ones that get a lot more troubled in market weakness. Likewise, if you are up a lot in a name and you aren’t exactly sure why (but happy to see it), now may be a time to take some profits.

4. Don’t sell medium-term “core” positions. I’ll cite two reasons. A recession and its twin — a grinding bear market — don’t appear to be on the horizon. Plus, it’s tough to “trade around” market moves because you have to get two decisions right -- the sale and the buyback.

5. Turn a little defensive. Consider dialing back exposure to high-beta groups like tech, industrials and biotech. Instead, weigh dabbling in exchange-traded funds that go up when the market goes down. For this, take a look at ProShares Short S&P500 SH, +0.54% ProShares UltraShort S&P500 SDS, +1.12% ProShares Short Dow30 DOG, +0.76% and ProShares Short QQQ PSQ, +0.64%

Here’s a closer look at three reasons the market “feels” a little toppy here.

1. Sentiment is overheating

I track about a dozen sentiment indicators to get a handle on the mood of investors. The tactic is to get cautious when the crowd is bullish and vice versa. Right now, all of the indicators I track are showing fairly widespread complacency among investors. So they are neutral at best, or bearish in the contrarian, go-against-the-crowd sense.

Complacent investors who casually pick up exposure to the markets are more likely to be “surprised” when bad news hits. They’ll sell faster than more seasoned and cautious investors would, which can get the ball rolling to the downside pretty quickly.

Examples? The Chicago Board Options Exchange (Cboe) 10-Day Put/Call Ratio recently fell below 85%. That’s a common cutoff below which this ratio signals excessive bullishness. Below that level, the ratio tells us investors are buying fewer puts (a bearish bet) compared to calls (a bullish bet). Next, the Cboe Volatility Index VIX, +5.14% recently fell back to around 12, another sign of complacency.

Also consider that flows into equity ETFs over the past two months have been the strongest since the start of 2018. And short interest in the SPDR S&P 500 ETF Trust SPY, -0.53% Invesco QQQ Trust QQQ, -0.75% and iShares Russell 2000 Value Index IWN, -0.21% are at the lowest levels in many years.

On the anecdotal front, people who aren’t normally market types are contacting me for stock ideas. And more investors are boasting to me about their gains, even when they are in stocks or funds that are lagging the market. There’s nothing scientific about anecdotal signals like these, but they are worth paying attention to, and you should cultivate these kinds of contacts in your own circles.

Whatever you think of President Donald Trump, he offers a telling market sentiment read, too. A go-to stump speech line of his is the observation that everyone thinks they are genius investors now because their portfolios are up so much — a comment he couches in not-so-thinly veiled sarcasm. Of course Trump being Trump, there’s an ego battle at work here, because he wants to claim all the credit for the market rally.

But he’s also making a relevant point about investor sentiment that is worth heeding. When the market is posting steady gains, many investors start to think they are a lot smarter than they really are — another sign of overconfidence and complacency.

2. Market breadth narrowing

Meanwhile, as narrow indexes like the S&P 500, the Dow Jones Industrial Average DJIA, -0.78% and Nasdaq continue to climb, fewer stocks are participating in the rally.

Case in point: Apple AAPL, -0.67% Amazon AMZN, -1.22% Facebook FB, -1.15% and Microsoft MSFT, -1.27% contributed nearly 50% of the overall Nasdaq gains in April, says Bruce Bittles, the chief investment strategist at Baird. Also, he notes that the percentage of Nasdaq stocks trading above their 50-day moving averages recently dropped to 57% from 80% on March 1.

In addition, the Dow industrials, the Dow Jones Transportation Average DJT, +0.77% and the Russell 2000 RUT, -1.37% have yet to confirm the new highs hit by the S&P and Nasdaq indexes.

Fewer stocks participating in the narrow index gains is just another way of saying a pullback is already beginning. But you haven’t noticed it yet if you only track the S&P 500 or the Dow, like a lot of people do.

3. Seasonality turning against us

The “Sell in May” market lore is certainly not infallible. But we are exiting the time of the year for seasonal cash inflows (January through April), and moving into the summer and fall months which often see sharp selloffs.

Possible bull breakers ahead

What might spark a selloff? That’s anyone’s guess but here are some possibilities.

• The economy disappoints again. First-quarter GDP posted nice 3.2% growth, but that’s not the full story. Much of the growth was due to inventory building and trade, which will prove to be temporary, says Doll. Domestic sales were the weakest in three years. He expects second-quarter growth will be around 2%.

• Political tensions heat up even more. As we move deeper into the 2020 election campaign, Washington, D.C. could produce more drama in the form of fresh investigations, court battles and scandals. Wall Street has been ignoring the political circus, but that won’t necessarily persist.

• Trade issues don’t go away. Sure, the U.S. and China could reach a trade settlement, maybe in late May or early June. “But we don’t think trade tensions between the two countries will go away,” says Doll. U.S. trade tensions may also heat up with other countries.

• Inflation comes back. We continue to see little evidence of inflation, and that suits the markets just fine. Technology, trade and the aging of the population are putting downward pressure on prices. But the labor markets are tight. So wage inflation could spill over into consumer prices at any moment. That would send bond yields higher, which would spook the stock market — just like last year.

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