NYSE Margin Debt CloseThe key stock indices have been rising since the beginning of the year, and there is still room for them to rise even higher as optimism concerning stocks continues to grow. But the risks associated with the stock market are piling up very quickly—investors may be standing in front of a train wreck.

I continue to believe the key stock indices have been propped higher by unprecedented money printing by the Federal Reserve. I say this because the fundamental reasons behind the stock market rally are just not there.

Companies on the key stock indices are struggling to get sales going. McDonald’s Corporation (NYSE/MCD), the fast food giant, reported that its global same restaurant sales fell 0.6% in April. In its Asia/Pacific territory, sales plummeted 2.9%; in Europe, they declined 2.4%; and sales only rose 0.7% in the United States. (Source: Reuters, May 8, 2013.)

The demand from consumers is anemic. Businesses are building up inventories. Data from the U.S. Census Bureau showed that inventories at merchant wholesalers increased 0.4% in March compared to February, and they were up 4.7% from a year ago. (Source: U.S. Census Bureau, May 9, 2013.)

As of May 3, the majority of the companies on the S&P 500 had issued their corporate earnings. Only 47% reported sales above earnings estimates—the average for beating sales estimates over the last four quarters was 52%. (Source: FactSet, May 3, 2013.)

And of the companies that have provided corporate earnings guidance for the second quarter of 2013, almost 79% of them issued a negative outlook; they expect their corporate earnings to be lower.

Meanwhile, investors are taking much higher risks. Let’s look at the margin debt at the New York Stock Exchange (NYSE), for example. In March, it reached $379.5 billion, 28% higher than last year at this time. In March of 2012, the margin debt on the NYSE was $295.9 billion. (Source: New York Stock Exchange web site, last accessed May 10, 2013.)

Margin debt on the NYSE is very close to what it was prior to the broad market sell-off in the key stock indices during the financial crisis.

Increased margin debt means that even a minute fluctuation in the key stock indices could turn into panic selling, as a fall in stock prices will cause investors to close their positions to meet brokers’ margin requirements.

With the key stock indices posting new highs on a regular basis, it is certainly tough to be a bear, but I am sticking with my opinion. The fundamentals that drive the key stock indices higher—corporate earnings and sales growth, consumer demand and better economic conditions—are just not present. And there is far too much optimism in the marketplace—a classic trap for investors.

Michael’s Personal Notes:

The U.S. housing market is still under stress, and it will take a very, very long time for it to recover. Take a look at the chart below of the S&P/Case-Shiller Home Price Index—the most prominent indicator followed by economists to assess the health of the U.S. housing market.

Chart courtesy of www.StockCharts.com

Now consider this: if a stock goes down by 50% one day, and then increases 10% the next day, has the price recovered? The U.S. housing market is in a very similar situation. Yes, home prices have increased since they hit their lows in late 2011, but they are far from recovering. The S&P/Case-Shiller Home Price Index clearly shows that home prices are down significantly from their peak in 2006–2007.

What else is wrong with the U.S. housing market? According to the Mortgage Bankers Association’s (MBA) National Delinquency Survey, the delinquency rate for mortgage loans on one-to-four-unit residential properties increased to 7.25% of all outstanding loans at the end of the first quarter of 2013. (Source: Mortgage Bankers Association, May 9, 2013.)

And that’s not all. CoreLogic data showed that 10.3 million homes with a mortgage in the U.S. housing market had negative equity—meaning the price of the house was much less than the amount borrowed at the end of 2012. (Source: CoreLogic, March 19, 2013.)

To give you an idea about how negative the situation in the U.S housing market still is, in Nevada, more than 52% of properties with a mortgage have negative equity. Other states like Florida, Arizona, Georgia, and Michigan have a significant portion of homes with negative equity as well

With all this said, one question rises: where is the U.S. housing market headed next?

In his essay in the New York Times, Robert Shiller, founder of the S&P/Case-Shiller Home Price Index, commented on the direction of the U.S. housing market, saying, “Forecasting is indeed risky, because of factors like construction productivity, inflation, and the growth and bursting of speculative bubbles in both home prices and long-term interest rates. The outlook is so ambiguous that there is no single answer to the question of housing’s potential as a long-term investment.” (Source: Shiller, R.J., “Today’s Dream House May Not Be Tomorrow’s,” New York Times, April 27th, 2013.)

The reality of the situation is that the road ahead is more uncertain now than it was before. I look at first-time home buyers as a key indicator of sustainable growth in the housing market. Unfortunately, even with mortgage rates at a record low and home prices being reasonable, first-time home buyers are not there.

What He Said:

“Over the past few weeks I’ve written about subprime lenders and how their demise will hurt the U.S. housing market, the economy and the stock market. There’s no escaping the carnage headed our way because the housing market and subprime business are falling apart. The worst of our problems, because of the easy money made available to borrowers, which fueled the housing boom that peaked in 2005, have yet to arrive.” Michael Lombardi in Profit Confidential, March 22, 2007. At the same time Michael wrote this, former Federal Reserve Chairman Alan Greenspan was quoted saying, “the worst is over for the U.S. housing market and there will be no economic spillover effects from the poor housing market.”