By Justin Ford

Let’s get right to it. Drum roll, please…

10.  Irrational Exuberance gives way to Incomprehensible Elation. In the midst of the worst recession since the great depression, on the heels of a 50% stock rally in six months and just before a new major wave of housing foreclosures and a likely commercial real estate bust… Wall Street is selling stocks like there’s no tomorrow. A screen of 5,817 actively screened stocks yields just 154 with a “sell” rating. That’s one out of 38. At the height of the tech boom, it was one out of 29.

9.  The “Invisible Bailout” reaches record levels. This is the bailout no one’s talking about—executives bailing out of their company’s shares! Trim Tabs reports the highest level of insider selling since they began keeping records in 2004, with insiders dumping $105 billion of stock during the rally. That’s 31 times greater than the pace of insider buying. This is almost the exact opposite of Wall Street’s sell-rating ratio. Well, the sharks have to sell to someone, and brokers appear to be lining up the minnows to take the CEO’s shares off their hands.

8.  Ugly is beautiful and bad is good. Excessive credit caused the crisis we’re in but you wouldn’t know it by looking at the stock market. A recent survey of public companies showed those with the worst credit ratings have led the rally—soaring 89% while the S&P 500 rose 53%.

7.  The Rally is long in the tooth. We’ve had greater rallies than the current one but not longer ones—at least not after major crashes. The longest rally during the 1929-32 bear market was 155 days. We are on day 204 of the current rally.

6.  A New Wave of Housing Foreclosures will begin in the 4th quarter. Loan modification plans have been largely ineffective because banks have been stingy and loan servicers don’t have the authority to modify many of their loans. Consequently, many foreclosures that have been postponed until now, will be postponed no longer. They’re going to happen. And there are quite a few of them. Mortgage companies hold 1.2 million loans on which they haven’t received a payment in 90 days, another 1.5 million that are “seriously delinquent,” and 217,000 that haven’t received a payment in over a year. In all, 3 million new foreclosures could come on the market in the next year, further depressing real estate prices. A big chunk of those could happen in the next few months. “We are going to see a spike from now to the end of the year in foreclosures as we take people out of the running,” a Bank of Ame rica spokeswoman told The Wall Street Journal last week.

5.  Dirt-cheap mortgage money may come to an end soon. If you can get a mortgage today, the money is as cheap as it’s ever been—about 5% for a 30-year fixed-rate loan. But that may not last long. The Fed has bought 80% of the Freddie Mac and Fannie Mae mortgages since the crisis began. Private investors still aren’t interested. What’s more, the Fed’s $1.25 trillion program for buying these mortgages is two-thirds done and scheduled to finish at the end of the year. If the government doesn’t incur more debt to buy this debt, rates will rise and put a further kibosh on the decimated housing market. And all these housing woes don’t even count the considerable trouble brewing in the commercial real estate sector…

4.  The Crisis in Commercial Real Estate is just beginning. Delinquencies on commercial real estate loans recently rose above 3%. That’s more than six times the level of a year ago, but it’s likely only the beginning. Double-digit unemployment and a chastened consumer’s are causing office and retail vacancy rates to rise and rents to plummet. Making matters worse, most lenders finance commercial properties with balloon loans. These are typically due in full after just five, seven or ten years, and loose-money loans originated in ’05 and ’06 are now coming due. Yet since values are falling many commercial property owners will not be able to refinance. The problem is widespread too since commercial real estate loans are usually the bread and butter of local banks. Only ten major banks made up the bulk of the housing lending market. Yet, according to The Wall Street Journal, more than 3, 000 banks and savings institutions have more than 300% of their risk-based capital in commercial real-estate loans. And almost $100 billion of their loans coming due in the next three years may have difficulty getting new financing.

3.  The Consumer isn’t coming to the rescue, as hoped. Consumption is the biggest component of the U.S. economy—but getting smaller. Unemployment is at 10% by official figures (over 20% according to Shadow Stats); there are six job hunters for every job opening and 52% of job hunters say they’re exhausting benefits before they find that next job. Credit card delinquencies are up 60% and 7.6% of all U.S. households were late on their mortgage last month!

2.  October is a scary month. OK, there’s nothing very scientific about this one, but October is the month for Halloween and major market crashes. Past Octobers have seen intra-month plunges of 41% in 1929; 39% in 1987; and 29% last year. As we enter month seven of a record rally, this odd piece of history may replay yet again.

And the number one reason the market could be topping…

1.  The number one Predictor of Collapsing Share Prices just issued its first sell signal in 226 days. The predictor is The Credit Crunch Short Indicator. It consists of four criteria that appear very rarely together in any one stock. The first identifies a company that is going through a credit crunch. The second and third confirm the situation is getting worse. The fourth indicates the credit problems are beginning to show up in the share price.

The one problem with the indicator is that it is extremely selective. It doesn’t tell you when to short an index or a mutual fund or ETF. And it doesn’t try to catch all falling stocks. It only targets the ones that are the “weakest links” financially.

But when it triggers, it has proven to be very accurate. And when it doesn’t find easy pickings, it’s as silent as a church mouse. In fact, during the recent bull market rally the Credit Crunch Short Indicator didn’t issue a single sell signal in over seven months. After averaging over two a month covering nearly a three-year period, it went dead silent. Until last week.

Then, like a reliable old boiler kicking on again the first cold day of winter, it revved up and spit out a brand new sell signal. Two months ago, during the height of the rally there were none. But now seven are “knocking on the door” with three criteria for shorting confirmed and only a few points away from a possible 4th criterion and another “sell signal.”

The point is that when the most selective indicator we’ve ever seen begins to issue sell signals, it is another good reason to keep an eye on the exits and take action to protect your capital and possibly even make significant profits in the next market correction.

In itself, a 50%+ rally in just over six months should be enough to give even the most bullish investors pause. But combined with other unpleasant news on the horizon and the sudden “talkativeness” of one of the market’s most selective indicators… it all leads me to believe it’s time to take some defensive action.

What’s that mean?

• Buy gold if you haven’t already. If a market correction turns into a panic even for a little while, you could see gold and silver rise smartly. And if it’s a dull steady decline, gold tends to hold when paper assets fold.
• Set stop losses on your long positions. It could be 20% or 25%. They could be market stops or mental stops (which makes you responsible for placing the sell order when the shares drop 25% from their high). Either way, pay attention to your stocks, especially in broad market declines and stick to your strategy for protecting gains and preserving capital.
• Look for opportunities to make money on the short side, profiting from falling share prices by targeting the most financially vulnerable companies, waiting for technical price confirmation before placing your trade, and again—having a stop loss in place.

They say an ounce of prevention is worth a pound of cure. It’s time to take a few ounces.

Sincerely,

Justin Ford