US data looms over stock markets

But the end of recent rallies could be useful corrective for investors

TOO good to be true? That’s the growing worry among US equity investors. Consider that the Dow Jones Industrial Average, up roughly 6 per cent since 1 January, is off to its best start in more than two decades and now sits within 2 per cent of its record closing high. The S&P 500, for its part, just closed above the 1,500 level for the first time since 2007, and recorded an eight-day winning streak – its longest in more than eight years.

It’s not that the rally isn’t justified. The past six weeks have seen a steady improvement in US growth prospects and, perhaps more importantly, a temporary resolution of the “fiscal cliff”. China is still growing, Japan is shooting for the moon, and Europe is hanging together. America’s housing market is heating up again and corporate earnings are good enough to be generally ignored.

It’s all coming up roses, in other words. But just as retail investors are warming to the stock market, some of the professionals would like to see things cool off. A January record of $55bn (£34.9bn) has poured into equity mutual and exchange-traded funds already, according to TrimTabs, with several trading sessions still left. Almost 80 per cent of the stocks in the S&P 500 were overbought last week.

“We would very much like to see a modest and typical sell-off (5 to 7 per cent),” wrote BTIG strategist Dan Greenhaus in a weekend client note. “We think such an event would help work off some of the excesses investors are building up.”

What’s interesting, however, is that post-crisis sell-offs have actually tended to be more severe than in the past. Double-digit drawdowns have become the new norm, as Societe Generale notes; they are both a cause and effect of the general portfolio allocation away from equities and into credit, particularly among insurance and pension funds.

Investors, then, ought to be careful what they wish for; and this behaviour, while it lasts, is also a reminder that healthy “old normal” market conditions haven’t returned just yet.

Still, there is another sense in which a sell-off could be useful. Just as people often learn more from errors than from success, so too investors might glean from any correction a clearer sense of the market’s next major move. A sell-off, spurred by a hawkish statement tomorrow, following the Federal Reserve’s two-day policy meeting, is far different from a sell-off spurred by a disappointing US jobs report on Friday. The former suggests fundamentals are firm enough to warrant less central bank policy support; the latter, that they are not.

The looming budget sequester – the automatic spending cuts slated to begin on 1 March – serves as a similar litmus test. If stocks start to sputter on every hawkish comment from a senator or congressman in Washington, it’s a sure sign investors still aren’t fully confident that private-sector growth alone can power the US.

Kelly Evans is a CNBC anchor. You can follow her on Twitter @Kelly_Evans