Image: Bull © Photographers Choice RF, SuperStock

Are we looking at a yearend "melt up"?

I think the odds are good -- very good indeed -- that we’ll see one of those big, all-animal-spirits-on-deck upward moves in U.S. stocks from now until at least mid-December.

That's assuming the markets get past this week’s Oct. 30 meeting of the Federal Reserve’s Open Market Committee without a move by the U.S. central bank to cut back on its $85 billion a month in monetary stimulus. And I think this is a relatively safe assumption after Monday’s report of a very disappointing 5.6% month-to-month drop in pending home sales in September.

Given that, I think the Standard & Poor’s 500-stock index ($INX) could easily break 1,850 within six weeks; up from a close of 1,760 on Friday, Oct. 25. That would add another 5 percentage points of return to what is already an extraordinary year for U.S. stocks.  As of Oct. 25, the year-to-date return for the S&P 500 was 25.4%.

But an end-of-the-year melt up wouldn’t be all good news for traders and investors. Because it could be a last hurrah.

Melting up, then melting down?

As the term implies, with its echo of “melt down,” stocks can fall hard after a melt up.

image: Jim Jubak

Jim Jubak

In a melt up, valuations run far away from any fundamentals in the economy, the market or individual stocks. A melt up is driven by momentum, as investors who have profited from the market’s gains greedily chase more and as investors who have been on the sidelines decide that they can’t take missing out any longer and join the party. Worries about risk go out the window, and often it’s the riskiest assets that climb the fastest. In a melt up, the last of every group of investors except the permanently bearish throws in the towel and finally puts cash into the market.

A melt up can be the last blowoff before a market dive.

“Can be” is, of course, the key problem. Melt ups don’t have to end in corrections or market dives. Best-case fundamental wishes can turn out to be true and provide support for valuations at exactly the right time. Extravagant hopes for the future can yield to even more extravagant hopes. Markets can calmly go through a period of consolidation rather than dropping to support levels.

Let’s start at the beginning and work through the important points one by one:

Why does this look like a melt up to me? What could make the difference between a dive, a consolidation, and a further extension of the rally? And what should you be doing now?

Almost everyone is a bull

Let’s start with sentiment indicators that say it’s very hard to find a bear right now.

The American Association of Individual Investors Sentiment Index for the week ended Oct. 23, for example, shows 49.2% of respondents are bullish -- that’s up 2.9 percentage points from the previous week. More impressively, bearish sentiment is down to just 17.6%, a drop of 7.3 percentage points. The long-term average for bearish sentiment is 30.5%, by the way.

It’s hard for a market to keep climbing when all the bears have already thrown in the towel and put their money to work on the bullish side.

Other indicators of sentiment, along with data on investor cash levels, show a similar picture of investor enthusiasm. Margin debt, money borrowed to buy stocks where the loans are secured by the value of the stock, hit a 54-year high in September at $401 billion. (The New York Stock Exchange only releases data at month’s end, so we don’t know what has happened to the total in October.) Margin debt as a percentage of GDP does not quite match the peak of 2007, but it’s in the neighborhood of previous peaks, according to Deutsche Bank.

You can see signs typical of a melt up by tracking the rise in popularity of riskier assets. For example, mutual funds and ETFs (exchange traded funds) that invest in junk bonds are popular again. Weekly flows into junk-bond funds have tripled to $2 billion, according to Lipper. That has taken total cash flow for the year back into positive territory after investors moved out of the category earlier in 2013.

Or take the willingness of Wall Street to buy what are called covenant lite loans. These corporate loans carry few covenants -- rules, for example, requiring borrowers to meet specific credit ratios or limiting the amount of additional debt borrowers can take on. Covenant lite loans had climbed to 54% of all loans this year as of September, according to Standard & Poor’s. That’s a record.

Can the rally keep rolling?

So what could keep this melt up from ending badly -- that is, in a dive or a correction? (And remember that this market hasn’t seen a 10% correction since December 2011.)