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Three Reasons to Remain Cautious on Stocks

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Thursday, October 8, 2015
Money and Markets
Three Reasons to Remain Cautious on Stocks
by Mike Burnick

Dear ,

Mike Burnick

In my last Money and Markets column, we took a closer look at the typical road map for a stock market bottom and some of the key indicators to look for to help determine if the lows have been made.

The S&P 500 Index came very close to retesting its August low last Tuesday, when the index slipped under 1,872 before reversing to the upside.

That's close enough to the Aug. 24 low of 1,867 to count as a double-bottom in today's volatile market.

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So is that it? Is the bottom in? I'm not so sure for several reasons. And I see at least three possible scenarios ahead for stocks, only one of which is truly bullish from here.

Let's take a closer look at three good reasons to remain cautious for now.

First, the S&P 500 is a price-weighted index and right now a handful of big-name stocks are masking the true damage done to the broader stock market during the recent correction.

In fact, while the S&P 500 has rallied nearly 7% higher off of its low, four out of 10 stocks in the index have already slipped below their August low prices. The chart below tells the true story.

Click image for larger view

It shows the S&P 500 Equal Weighted Index, which counts each stock evenly, regardless of size. As you can see, this index slipped to a new low recently, in sharp contrast to the cap-weighted S&P 500.

Likewise, the broader Russell 3000 Index, with a mix of large- and small-caps, also fell to new lows recently, as did the Russell 2000 Index of small cap stocks.

The big-cap institutional favorites are doing all the heavy lifting, making the index appear stronger than it really is. In fact, just three stocks — XOM, AAPL and Microsoft Corp. (MSFT) — account for nearly 20% of the gains in the S&P 500 since the bottom.

This kind of narrow market leadership while so many other stocks are slipping to new lows is a troubling sign.

Second, another big concern, which my colleague Mike Larson has pointed out, is rising credit stress in the corporate bond market, and that's troubling because this is the same red flag we saw during the financial crisis in 2008 and again in 2011!

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The graph above shows the Merrill Lynch U.S. High Yield Index. It tracks a basket of junk bonds, which are sensitive to changes in the economy and financial conditions in general.

As you can see, the high-yield index plunged to new lows last week, undercutting the August low by a wide margin. High-yield bonds are considered a leading indicator for stocks, so with this index still in freefall, it could be a warning of a deeper selloff ahead for stocks.

Third, typically at this time of year, investors look forward to strong seasonal fourth-quarter returns from the stock market, and perhaps a rally into year-end, but that may not be in the cards this year.

The three months from October–December is statistically the best time of year to invest in stocks, with the S&P 500 up 72% of the time while posting a median gain of 4.4% over this period! But when the S&P 500 is locked in a down-trend heading into the fourth quarter, stocks tend to keep declining into year-end.

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This year, the S&P 500 is down 6.7% through the end of September. As you can see in the chart above, when stocks are down entering the fourth quarter, they continue to fall an average of 0.7% over the final three months of the year. In fact, if the market stays on this historical path, there's only a 10% chance stocks can finish up for the year.

Bottom line: There are really only three possible scenarios stocks can follow from here.

Scenario #1: S&P rallies through resistance at 2,000 and then faces even more difficult resistance to further gains from 2,050 to 2,130.

Scenario #2: S&P turns lower at one of these key levels for another retest of the August low, or perhaps falls into a deeper correction.

Scenario #3: S&P enters a new trading range similar to the first six months of this year, but at a new lower level; range bound between, say 1,870 and 2,000.

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While this last scenario might seem frustrating, it might also be the best possible outcome if you're a long-term investor. That's because the best, highest-quality stocks with strong sales and profit growth will get cheaper as time goes by while their earnings keep growing.

Another trading range will be a stock-pickers market. If so, then focus on the highest-ranked stocks according to our Weiss Stock Ratings model.

As these stocks grow more attractively valued, investors will start snapping them up again.

Good investing,

Mike Burnick

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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