Navigating an Overvalued Market, Part I

 | Feb 21, 2013 | 10:00 AM EST
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Investors were shaken out of their complacency Wednesday. After seven straight weeks of gains, the market finally had a significant selloff. It was the Dow Jones Industrials' second-worst day of the year and the Nasdaq and the S&P 500 both posted their biggest losses since the post-election pullback in November.

The ostensible reason for the decline was minutes from the Federal Reserve's FOMC meeting showing a divergence of opinion on whether extraordinary measures to support the market and economy -- quantitative easing -- should continue. I have been increasingly skeptical of this market since the huge rally in January, when the market posted its best start to a year in over a decade. Over the last few weeks, I have moved all the money I put back into the market after the dip in November back into cash. I have also taken advantage of low volatility to purchase cheap insurance on the rest of my portfolio by buying slightly out-of-the money puts on the S&P 500 as a hedge should the market continue to fall. There are two main reasons for my pessimism about the market's short-term prospects.

First, I don't believe the market has fully factored in a slowdown in consumer spending that appears forthcoming. I am very much aligned with Doug Kass on this issue and I'm substantially underweight sectors dependent on spending from the consumer. The payroll tax holiday eviscerated about $120 billion annually from consumers' pockets. In addition, record high gas prices for this time of the year is also providing a solid headwind for consumer spending. Wal-Mart (WMT) alluded to this pressure in its leaked internal emails last week. It also looks like the retail behemoth's revenues came in a bit light for the fourth quarter and its first-quarter guidance of $1.11 to $1.16 per share was below a consensus of $1.18.

My second major worry for the market is around earnings and the trend in earnings estimates. I want to give a big shout-out to Gary Dvorchak, who highlighted this in an excellent column Wednesday. The market has managed to produce nice returns over the last year, even as S&P earnings estimates for 2013 have declined significantly over that period (see chart below).

Source: Factset using First Call Estimates

This means investors are paying significantly more for a dollar of S&P earnings than they did one year ago. Quarterly earnings estimates are also discouraging, and I believe investors have been taken in by some of the typical analyst games. For example, at the end of the third quarter, the consensus for fourth-quarter earnings forecast an approximate 9% gain year over year. By the end of the fourth quarter, consensus estimates called for a 1% to 2% gain year over year. When earnings came in with an approximate 4% gain, the market celebrated with a continued rally, even though earnings look like they will come with about half the gain compared to where the consensus estimate was four or five months ago.

I expect the market to give up a good portion of its gains for the year over the next few weeks as we navigate the sequester cuts and until the market has a better feel for what consumer spending will actually be like going forward. I do not expect a major correction, but the first pullback in months is very likely.

Tomorrow, I will highlight a few picks on my shopping list that I would like to buy 5% to 8% lower than current price levels. I will also discuss a few of the bull call spreads I am using to mitigate any underperformance from my decent-sized cash position if the predicted decline does not materialize.

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