Current Stock Market Euphoria a Carbon Copy of 2007?

Increasing optimism towards the key stock indices worries me. In the beginning of 2013, you would hear the bears’ opinions all over the financial news channels. Now, it seems they have all disappeared—or have turned outright bullish. No matter where I look, it’s pretty much the same opinion across the board in the mainstream: key stock indices are going higher, they say.

When I see all this, a quote from Sir John Templeton comes to my mind. He said, “Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” (Source: SirJohnTempleton.org, last accessed December 11, 2013.)

You see, I remember exactly what happened in 2007. The opinions toward key stock indices back then were similar to what they are now. I remember watching financial news channels that were overrun with optimistic views on the key stock indices. We were assured nothing was wrong and all was well. Those who spoke against the rising stock markets, the news anchors laughed at them and questioned if they were still in touch with reality. Following this, we saw one of the worst sell-offs on key stock indices in history.

As it stands, the optimism towards the key stock indices today is increasing, while the fundamentals that drive the markets higher are weakening.

For example, corporate earnings outlooks—the main driving force behind the stock market—are looking grim. One can get a general idea of corporate earnings by looking at the guidance provided by companies on the key stock indices. Companies know their business and can see when conditions change well before anyone else.

For the fourth quarter, companies on key stock indices look worried.

Consider this: as of December 6, 103 S&P 500 companies had provided guidance about their corporate earnings for the fourth quarter. Sadly, almost 90% of them issued a negative outlook about their corporate earnings. (Source: “Earnings Insight,” FactSet, December 6, 2013.) This is something you don’t want to hear when you are betting on a rally in the key stock indices.

This optimism we see now shouldn’t be taken lightly; it can tell us where the key stock indices might be going next.

With this, one must wonder, have they reached the top? Are we in a state of stock market euphoria?

As I’ve written in this column before, it’s impossible to predict the exact tops and bottoms on key stock indices. Increasing optimism certainly indicates that we might be nearing a top, but time will draw a better picture.

You have to keep in mind that this can go on for a while. Irrationality tends to stretch, but reality will eventually strike. The key stock indices made a top in 2007, but then the sell-off didn’t really come until late 2008.

Looking at the behavior of the markets, it seems the irrationality trade is still on. In the near term, key stock indices might head higher. As this happens, investors should remain very cautious, and not take unnecessary risks in order to gain that one extra percent of profit, as this could greatly hurt their portfolio if the market finally does turn.

Instead of reacting to short-term market gains, investors should consider taking preventative steps to protect their portfolio in case the key stock indices turn unexpectedly. One option is to take some profits off the table—by doing this, the worst-case scenario is still profit. At the same time, investors could consider placing a stop loss on their holdings to minimize their potential losses. Finally, investors may hedge against a decline in the key stock indices—and, in fact, even profit from it—by looking at exchange-traded funds (ETFs) like ProShares Short S&P500 SH. This ETF increases in value by one percent for every one-percent decline in the S&P 500.

This article Current Stock Market Euphoria a Carbon Copy of 2007? was originally published at Daily Gains Letter