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Stocks’ Friday drop may not spell end of rally

Goldman Sachs & Co. reminded investors that the stock market can still go down.
/ Source: The Associated Press

Goldman Sachs & Co. reminded investors that the stock market can still go down.

The government charged the bank with civil fraud Friday and the Dow Jones industrial average fell 126 points, its biggest slide in more than two and a half months. The Goldman Sachs news gave a dose of reality to investors who were used to seeing the market climb almost relentlessly on signs of a recovering economy.

But there are signs investors are already shaking off the Securities and Exchange Commission's charges that Goldman Sachs failed to tell clients about conflicts of interest in mortgage investments it sold. Stocks ended off their lows Friday. That's a sign that investors are still making predictions that stocks will bounce higher.

"They've been conditioned to buy the dips and they've been rewarded. It's like a Pavlovian thing," said Alec Young, equity strategist at Standard & Poor's. "The road is littered with the bodies of people that have predicted a pullback in the last couple of months."

It's easy to see from recent news why stocks are trekking steadily higher. Big companies like chipmaker Intel Corp. and financial firm JPMorgan Chase & Co. last week posted huge profit gains for the first three months of the year. The government reported that employers added jobs in March at the fastest rate in three years. Sales at chain retailers posted the biggest gain last month in more than 10 years.

The problem is that stocks haven't had a break, and that makes the market more vulnerable to a big drop. The Standard & Poor's 500 index has risen 76 percent since it hit a 12-year low in March last year. There have been five periods since then when it lost 5 percent to 8 percent. But those drops still don't count as a full correction, which most analysts say is 10 percent.

Standard & Poor's Equity Research predicts that the S&P 500 index will reach 1,270 in the next 12 months but that a drop of 5 percent to 15 percent along the way is possible. The S&P 500 topped 1,200 last week for the first time since before the worst days of the financial crisis in late 2008. To get to 1,270, the index would need to go up 6.5 percent.

By one measure of the market, stocks are overheated. Yale professor Robert Shiller compares share prices of S&P 500 companies to their average earnings over 10 years. Based on data going back more than 100 years, stock prices are about 51 percent overvalued, he said. He cautioned that doesn't mean a crash is due but that stocks are above their norms.

"It's kind of pricey now," Shiller said.

Analysts see other signs that stocks need to stop climbing for a while:

  • In the past two months, the Dow has gone up three out of every four days. Last week, it closed above 11,000, a level it hasn't seen since September 2008. Little more than a year ago, it was near 6,500.
  • Ninety percent of the companies in the S&P 500 index are trading above their average price of the prior 50 days. That hasn't happened since 1994 and it's an indication that prices are elevated.
  • The Chicago Board Options Exchange's Volatility Index, which is known as the market's fear gauge, last week closed at its lowest level since July 2007. That meant there fewer investors are predicting big drops in the market. The VIX did spike 15 percent Friday after the Goldman news.
  • Last Tuesday — a quiet day for investors — the trading of five stocks accounted for one-fifth of the market's volume. Four of the stocks were under $5. That points to traders making a quick buck by swapping cheap stocks, according to Joe Saluzzi, co-head of equity trading at Themis Trading LLC. "It's one baseball card being traded back and forth a thousand times," he said. "It's an illusion." Investors often look to higher trading volume as a sign of broad confidence in the market's direction.

Analysts say a drop will occur when something comes along that investors didn't know about or had managed to forget about. Friday's Sachs Goldman news was one of those surprises. Beyond that, investors know unemployment remains high at 9.7 percent and that the housing market is weak. They also know that the Federal Reserve is starting to turn off the spigot of cheap cash that has propped up banks and flooded in the stock market.

While no one can say when the market will fall, many analysts predict stocks could stumble when the Fed starts to boost interest rates to avert inflation.

"There is a lot of partying going on because I think the Fed has been fueling the fire with extraordinarily cheap money," said Haag Sherman, chief investment officer at Salient Partners in Houston, referring to low interest rates. "I do think that's the big question, which is how the market will respond to that."