S&P 500 is on the edge of a painful correction

THE SCOTTISH journalist Bertie Charles Forbes once said: “Optimism is the stuff of which American business success is fashioned”. He would have seen much to be happy about in the USA now. Though unemployment remains stubbornly high, American investors at least are seeing the bright side.

The S&P 500 index of stocks has rallied by 8 per cent in the last three months and 2.66 per cent in the last month alone. At the end of last week, however, the index seemed to be struggling a little. Christmas is now long forgotten. Is it time for spread betters to prepare for a correction?

Kully Samra, a director at Charles Schwab, an American brokerage, argues that it’s possible. “Sentiment is a little frothy right now,” he says, “and earnings expectations are quite elevated”. Samra reckons that if a few American companies report disappointing results, it could trigger some profit taking.

He points to several indicators suggesting that market sentiment might be a little too optimistic at the moment. The SentimenTrader index measuring the gap between “smart money” and “dumb money” optimism shows a large gap emerging from around December, as “dumb money” got more confident and “smart money” less.

Similarly, individual investors (rather than institutional investors) are now more bullish than at any point in the last three years, while bearishness is very low. Interestingly, the last time the gap between bulls and bears was so large was in spring 2009, though then the gap was the other way around. That point was retrospectively described as the “mother of all market bottoms”.

So is this the mother of all market tops? Well, probably not, but spread betters would still seem wise to go short on the S&P 500, at least in the short term. Ben Barty-King, an options trader at ETX Capital, suggests that traders should watch the performance of the index quite closely. “The key pivot point is 1,268.5” he says. “If it stays above that level, then it could well keep going”. If not, Barty-King suggests the index could drop down to around 1,235 points.

It would also seem wise to watch individual stocks. The S&P 500 was sharply up on Friday after General Electric (GE) reported its results, but many more are coming. Halliburton and McDonalds release their report on Monday, while on Tuesday, Johnson and Johnson does, among others. Though more market shaking revelations on the scale of Steve Jobs’s announcement last week are unlikely, traders willing to follow individual companies closely might well profit from the swings in particular stock prices.

However, while it might make sense to be short at the moment, if the market does drop sharply, it might also present an excellent opportunity to buy. As Samra points out, this is a pre-election year, and historically, the American stock market has not dropped in a pre-election year since 1945. In fact, on average it has gained 17 per cent.

With large numbers of individual investors flocking back to the American stock market from bonds and from emerging market funds, it is not unreasonable to expect the US stock market to have another good year. Many American firms are sitting on large piles of cash, which may make for a boom in mergers and acquisitions, while consumer spending, manufacturing and earnings growth data are all solid. There are lots of very good reasons to be optimistic about the medium run performance of the market. But traders should perhaps wait a while – lest they be disappointed.