Proceed with Caution

This is one of those "the market will either go up, down, or sideways" posts. Read no further if that infuriates you.

The number of stock market bears seems to get smaller every day. It seems as though every new survey of market strategists and fund managers by publications like Barron's and USA Today says that now is the time to buy stocks, at least until March. We hit bottom in November, and now we're going to get a good bounce. Anchors on CNBC are reporting the folklore that an up January means an up year. Others are saying an up close on the first trading day of the year means an up year.

"All the bad news is priced in," "there are trillions of dollars on the sidelines, just waiting to get in," they've said everyday on the financial channels for the past two years. It is bound to be right eventually. Are they right this time? Who knows.

But even I feel more optimistic (which I view as a bearish signal). Despite almost daily bad news, the market is, as of writing, up near 20% since the November low, and many stocks still look tempting. Blue chips are sporting dividend yields not seen in a long time. The last two years' star stocks are trading substantially below their highs. How can investors not rush in?

Everyone seems to agree on two things: stocks should rally and there's a bubble in Treasuries.

When it comes to the markets (stocks, economy, etc), when everyone agrees on something, it usually turns out to be wrong. The greater the optimism, the greater the fall. The internet bubble, the housing and credit bubble, and the notion that investing in China was safe until the Olympics are examples.

There's plenty of scary stuff on the horizon. Noted economists like Paul Krugman say we'll probably have another depression. Others remind us that we're maybe about a third of the way through the credit bubble. Around a trillion dollars worth of subprime mortgages has led us to where we are now. In the coming months and years, around $1.5 trillion in adjustable rate and similar mortgages are going to reset. Credit card defaults are mounting. Commercial mortgage defaults are still coming. Many troubled borrowers who have renegotiated their mortgages  are defaulting again. Unemployment seems to be rising, while consumer spending is shrinking. Banks are not lending and are cutting existing lines of credit. Housing price declines are accelerating. State unemployment insurance funds are insolvent, and they are receiving so many new claims that their websites are crashing. The Federal government is borrowing heavily while the buyers of its bonds, mostly foreign investors, are starting to complain about the low yields.

Will stocks continue to rise if the S&P 500 and DJIA have negative earnings? It's certainly possible, since stocks rise and fall with expectations. During the Great Depression, the DJIA quadrupled from July 1932 to January 1937. 

Times can be terrible, but stocks can still go up. That's what the bulls are telling us now.

But consider the other side. From October 1929 to July 1932, the market lost around 88%. During the two and a half year period, there were a series of significant rallies. From January 1930 to April 1930, for example, the market went up 20%. It did this a number of times. There were at least six significant rallies that lasted weeks or months, all while the longer term trend was down. It was a step ladder down that gave opportunities to make up losses, but also drew in more buyers that ended up losing money.

The same sort of thing happened with the Nasdaq from March 2000 to October 2002. The index fell around 77% during the period, but had rallies that lasted weeks and months, some of which produced gains over 30%.

This just shows that there are periods of optimism during the longer term where the trend is significantly downward. Many of those who jumped into the market during the rallies, thinking that it hit bottom, were wrong. Was November 2008 the bottom, or just another step down? Who knows.

If you're one of those thinking that the market will head higher until March (and there are quite a few investors with this thought--I even heard it on the subway!), beware. Chinese stocks fell long before the Olympics started. Everyone thought, "it's safe until the Olympics, so I'll just sell early." Some arbitrary date before the Olympics, when the number of sellers was highest, turned out to be the peak. So if the market is supposed to be safe until March 2009, it's probably going to peak before then.

Buying blue chips now to lock in their high dividend yields is not a bad idea, especially if you plan to hold them forever. But remember, the market is more optimistic at the moment than it was a month and a half ago, and so can head lower. Don't spend all your money in one place, and have a plan. If you're holding stocks that you have paper losses on and you don't want to sell, you might consider taking advantage of rallies by buying puts on your positions during them. Now might be a great time to buy puts on stocks you already own.

As for the Treasury bubble that everyone is in agreement on (I've been eying puts on the iShares Long Term Treasuries ETF TLT for months), we can have low interest rates for a very long time. While it seems to make no sense to buy and hold a 30 year bond paying a dismal 3% while the government announces more borrowing and more spending, it might turn out to be a good investment. Look at Japan's years of low interest rates. (There are differences between the USA now and Japan during the last two decades, such as USA's terrible fiscal policy and the propensity of consumers not to save anything over the last few years. However, there are sufficient similarities to warrant the comparison.)

Even if bubbles aren't hard to see, it can be difficult to profit off of them. For example, the housing and stock market bubbles were readily apparent in 2005 and 2006. Your best clue was that everyone had two SUVs, a leased BMW, and a couple of houses while living from paycheck to paycheck. Shorting financials at that time would have made sense, but would only have brought you losses.

If you think the Treasury bubble will burst soon, there are a number of plays including: shorting TLT, buying puts on TLT, going long TBT (twice the daily inverse of the Lehman 20+ year index), or buying calls on TBT. 

All these involve risks. In short selling, your losses are theoretically unlimited. TLT shouldn't go too much higher, but everything is possible. Also note that short sellers have to pay the dividend on whatever they're shorting, and TLT pays monthly. Using puts instead limits your losses to whatever you buy the puts for, but if you don't time it right you can lose the entire position. Same thing with calls on TBT. And as for the ultrashort ETF, remember it's for a trade and not for the long term, particularly because it resets everyday (for example, the long index can go down over the course of a couple of months, but given enough volatility, the ultra short ETF can also end up down over the same period).

Disclosure: At time of writing, I was long SPY, long SPY March puts, and short SPY January calls.

More information is always better than less. Click here for analysis on any stock, commodity, currency, or ETF.