Beware of a complacent stock market

Complacency is a risky proposition, but there are some ways to hedge your risk.

By Stock Traders Daily Mar 16, 2012 2:03PM

Image: Stock index © Image Source/Getty ImagesAs better economic data has streamed across the news wires over the past two months, and Europe has -- for the moment, at least -- put a ring-fence around its sovereign debt issues, the stock market has developed a troubling case of complacency. 

There is little-to-no fear in the market, which to me is a blaring warning sign. 

Case and point: The iPath S&P 500 VIX ETF (VXX) is trading at its lowest levels since last August and is near all-time low levels. This, combined with the exuberance in the market, and the fact that it has reached a support zone at the $22 level make it an especially intriguing buy here.

To be sure, the economic picture has improved in the U.S. Employers aren't laying off nearly as many people, and have indeed picked up the pace of hiring. What's especially encouraging is that global construction companies, such as Caterpillar (CAT), have been pushing the accelerator the hardest. The company recently announced that it was expanding operations in both Georgia and South Carolina, adding thousands of new jobs.

Technology is another area where hiring has picked up. Social media, cloud/SaaS, and IT security, in particular, have been areas of strong growth, and companies are ramping up their sales forces and research and development departments to meet higher demand. Sourcefire (FIRE) is a company that converges SaaS and IT security, providing on-demand intrusion and malware prevention software. It's coming off a strong fourth quarter, and its stock has been "on fire." The stock gapped sharply higher on Feb. 22, the day after the company's earnings report, consolidated in a sideways pattern for a couple of weeks, and now looks poised to pop to all-time highs. During its conference call, management stated that it, too, plans to appreciably bump up hiring this year.

While this is, of course, good news, it could come at a price in the form of corporate bottom lines, and consequently, stock prices. Companies are picking up hiring at a time when they are already going to feel the pinch from rising energy costs. Combine this with the fact that the American consumer is still very cost-conscious, not seeing their paychecks increase by a meaningful amount in years, and there is a recipe for significant margin/earnings pressure. The bet here is that companies will begin to scale back on hiring, and that the jobs numbers will begin to look less rosy next month. Either way, it's a negative for the stock market.

There are, of course, other worries outside the U.S. that have been shoved to the back-burner following the string of encouraging economic reports. Much of Europe is in a recession, which could deepen, and the euphoria over Greece getting its bail-out will wane once people again realize that the issue is one of economic growth --  and there isn't any in Greece or in many other countries in the region. Without economic growth, there is no chance for debt holders to be repaid in full, no matter who is holding the paper. China is also slowing, which has been the No. 1 driver for earnings growth for many large multinational companies.

So, while it's futile to argue against the clear improvements in the economic data, I believe that there is a sense of complacency and that the market is set-up for a pull-back. I see one of two things happening in the coming months: The hiring data is going to weaken as companies deal with rising commodity costs, or first- and second-quarter earnings are going to disappoint as companies got ahead of themselves with hiring. 

With that in mind, there are a couple different ways to hedge against this risk. Treasurys have fallen out of favor lately as money has poured into equities, and the iShares Barclays 20 Year ETF (TLT) has pulled back as a consequence and is approaching a key support level around $110. 

Another easy way to hedge your risk is to buy the ProShares UltraShort S&P 500 ETF (SDS). The SDS, which is a leveraged exchange-traded fund (ETF) (it corresponds to two times the inverse of the S&P 500 Index), has been putrid over the past several months. That, of course, isn't surprising given the rally in the market, but it's looking like cheap insurance at the moment.

Mar 16, 2012 4:02PM
you may not believe in the rally, but short this market at your own risk.  When the retail investors come in a big way, that will be time to short.
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