What a Phone Call from My Aunt Told Me About the Stock Market

By Moe Zulfiqar

A few days back, I got a call from my aunt, whom I haven’t spoken to in a while. It was shocking to me—no, not her calling, but rather what she asked me. Before I go into any detail, here’s some background information: as an investor, my aunt has a little experience with the stock market, but gave up because it didn’t suit her low risk tolerance.

“I have been saving money for some time now; it’s been sitting in my bank account and earning next to nothing,” she said to me. She heard on the news that the stock market in the U.S. is going higher and that the S&P 500 has reached its all-time high—she wanted to know what I thought she should buy. “I think it’s about time I take some risk,” she added.

My aunt hasn’t bought stocks in a while; in fact, she has missed out on all the gains made since the stock markets bottomed in 2009.

What does this tell me?

I find this a little scary, as should anyone who has been following the stock markets for a while. What my aunt said makes me skeptical; it shows that the notion of missing out is emerging. In the past, we have seen the stock markets reach their all-time highs, which gave investors the feeling they were missing out on gains. They bought, the key stock indices increased a little, and then the sell-off occurred; they got caught in it and lost a significant amount of their portfolio. Historically speaking, there are many examples of this.

As this is happening, I see the fundamentals deteriorating.

To assess the stock market’s health, one factor I look at is the “surprise rate” of corporate earnings—namely, how much better profits are compared to analysts’ estimates. The higher the surprise rate, the better the move in the stock market is going to be.

Unfortunately, for the past few quarters, the surprise rate of corporate earnings has not been impressive at all. For example, in the third quarter of this year, the earnings surprise rate for S&P 500 companies was 1.7%. Over the last four years, this rate averages out to be 6.5%. If the corporate earnings surprise rate of the S&P 500 companies in the fourth quarter remains the same, then it would be the lowest since the fourth quarter of 2008. (Source: “Earnings Insight,” FactSet web site, November 29, 2013.)

Other factors, such as the margin debt (i.e., stocks purchased with borrowed money), continue to prevail. For example, the margin debt on the New York Stock Exchange NYX stands at $412 billion. This is the highest it has ever been. When the margin debt reached its highest in the past, we saw sell-offs on the stock market. (Source: “Securities market credit ($ in mils.) > 2010 – current,” NYSE Technologies Market Data web site, last accessed December 3, 2013.)

As all this happens, I continue to watch the stock market with skepticism. For now, the irrationality may continue and key stock indices may edge higher, but if the fundamentals don’t improve, reality will start to hit, which could cause a deep market sell-off. For now, investors like my aunt can safely profit from the stock market going higher through exchange-traded funds (ETFs) like the SPDR S&P 500 SPY.

This article What a Phone Call from My Aunt Told Me About the Stock Market was originally published at Daily Gains Letter