Market Bulls Root for a Pullback as Melt-Up Fears Mount

By MarketsFOXBusiness

This week the Dow Industrials clinched its 35th record close of 2013 alone, raising the chorus of market bulls who are calling for red-hot equities to take a much-needed breather.

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The thinking is that a so-called “melt-up” in the stock market could be damaging to the longtime bull rally by driving stock valuations out of whack with basic fundamentals, fueling a nasty selloff that erodes confidence.

Some market veterans already see signs of this kind of unhealthy market move, especially given the nearly two years since the last serious pullback, the Nasdaq Composite’s 36% 12-month surge and the frenzy created by unprofitable Twitter’s (NASDAQ:TWTR) debut last week.

“It’s starting to take on the tone of a bubble. Those don’t generally pop quietly,” said Peter Kenny in his first interview since stepping down as a managing director at Knight Capital Group (NYSE:KCG) last month. “I wouldn’t say it’s a full-blown bubble that’s ready to explode, but there’s certainly some investing going on that is not predicated on sound fundamental valuations.”

Bulls in Charge

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The clearest evidence of how trendy it has become to be bullish comes from the Investors Intelligence survey of investment advisor sentiment. The poll’s bull/bear ratio climbed to 3.54 last week, up from just 1.96 three weeks earlier, representing just the third time since 2003 it has eclipsed the 3.50 level.

“Almost everyone is bullish now,” Ed Yardeni, president of investment advisory Yardeni Research, wrote in a note to clients. Yardeni said he’s inclined to see the “elevated” bull/bear ratio as “another sign of a possible melt-up in the stock market.”

It’s easy to see why the sentiment has swung so far in favor of the bullish camp. The last-minute agreement in Washington to avoid a debt-ceiling breach and end the government shutdown lifted a huge cloud of uncertainty that had been lingering over the economy.

The fiscal deal turned attention back to the Federal Reserve, which surprised Wall Street in September by deciding not to dial back its easy money stimulus program. Fed watchers believe the central bank may not begin to scale back the $85 billion bond-buying program until March and even then policymakers may push back the point at which they will hike interest rates. 

“It’s almost as if the markets have called politicians’ bluffs that they would ever do anything seriously disruptive, and therefore markets are now presuming market-friendly outcomes to all political ‘crises’ absent clear and convincing evidence otherwise,” Scott Migliori, U.S. chief investment officer for equity at Allianz, wrote in a recent note.

Pullback Would be 'Healthy' 

Since the S&P 500 bottomed out at 1646 during the fiscal standoff in early October, the benchmark index has rallied about 8%, while the Dow Industrials soared more than 1,000 points.

“Even those who have really enjoyed this run would love to see some sort of reversion to the mean because it would give the market move much more sustainability. These types of runs tend to end unexpectedly and in ways that really drive fear into the way people look at their assets,” said Kenny.

Greg Valliere, chief political strategist at Potomac Research Group, echoed those concerns in a recent note, saying a “pullback would be welcome; an opportunity to cool the pervasive bullishness that the Fed has helped create.”

“Retail investors may be rejoining the party -- and when that happens, a correction is usually within sight,” he said.

It’s interesting to note the market hasn’t suffered a 10% correction since the 19% tumble between late April 2011 and early October of that year. Historically, the S&P 500 suffers a 10% drop once every 12 months, according to S&P Capital IQ.

A pullback “would be healthy because it would reignite some sideline cash,” said Mark Luschini, chief investment strategist at Janney Capital. “That would lead to ultimately higher market prices than this sideways grind we seem to be in the mist of at the moment.”

'Parabolic' Multiple Expansion

Luschini noted some concerning market metrics that suggest valuations have escaped fundamentals, including the fact that price-to-sales ratios for S&P 500 companies have climbed 55% above the median since 1970.

The strong demand for equities was also on display last week as Twitter (NASDAQ:TWTR) debuted as a public company 73% above its initial public offering price, prompting comparisons with the dotcom bubble.

There are also a number of stocks that have seen incredible upward moves that observers have at least partially attributed to mere momentum. Some hot names like (NASDAQ:PCLN), Netflix (NASDAQ:NFLX) and Tesla (NASDAQ:TSLA) have more than tripled the S&P 500’s year-to-date gains.

“Given this backdrop, it is not surprising that price-to-earnings multiples have continued to expand, in some cases in parabolic fashion (small caps, Internet stocks, etc.) raising the prospect of a ‘melt-up’ in equity prices as we enter the New Year,” Migliori said.

Elusive Pullback Could Remain Elusive 

So what could force the bulls to take their foot off the accelerator?

One potential obstacle is the Fed, which is pondering a shift in monetary policy just as it undergoes a leadership change.

While some believe a so-called “taper” of quantitative easing is already baked into the markets, others see a messy reaction from a market that has become addicted to easy money.

“I still think the tapering is going to unnerve investors. I think it’s a very delicate situation for the Federal Reserve,” said Luschini.

Keep a close eye on the yield of the 10-year Treasury note for signs the market is once again becoming jittery about QE.

Still, all of this talk about the markets needing to take a breather and a pullback being healthy, doesn’t mean it will actually happen.

“We believe those investors waiting to ‘buy on the dip’ are likely to be disappointed,” Brian Belski, chief investment strategist at BMO Capital Markets (NYSE:MBO), told clients in a recent note. “We believe recent performance patterns are not totally unprecedented.”

Belski pointed out that the current bull market has already produced as many 5% to 10% and 10%+ pullbacks as the prior six bull markets dating back to 1970, on average.

That’s why BMO is advising clients to continue to build positions in U.S. stocks “with a disciplined and more active investment approach” and believes the S&P 500 could touch 1,900 during 2014.

Luschini urged investors to “stay nervously long” and keep their exposure to stocks that have fundamental support to avoid feeling the brunt of an eventual correction. Whenever that may occur.

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