Stocks May Not Hit a New Peak Until Summer

Stocks have been booming, but strategists fear a coming correction before the run-up continues.

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Stocks are on a roll.

After a 12 percent gain in 2012, the S&P 500 stock index is already up by more than 5 percent in 2013. The market barely blinked at the fiscal cliff standoff last December, and the S&P 500 recently closed above the psychologically significant 1,500 mark for the first time since 2007

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The magic number is 1,565. That's where the S&P 500 closed on Oct. 9, 2007, the all-time high-water mark for stocks. After that, the market drifted down for a while, then plunged in late 2008 and early 2009 as the financial panic rattled investors. Stocks have been in a jagged but sustained recovery ever since.

The bull market finally seems to be drawing back investors who fled stocks when a rout was on and were reluctant to return. The flow of money into stock-based mutual funds has been picking up, as more people flee fixed-income securities, such as bonds, hoping to cash in on the run-up in stocks. The flow of money itself ought to push up stock prices, as demand for stocks goes up.

But investors may have to wait longer than they'd like for the stock market to reach a new all-time high. For starters, a glance at any stock chart will show that the bull market that's been underway since March 2009 has been an up-and-down affair, with major dips in the spring of 2010, the summer of 2011 and the spring of 2012. Another dip in the first half of 2013 would continue that pattern.

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Market strategists also worry that investors are becoming a bit too complacent and a correction could be brewing. Russ Koesterich, global chief investment strategist for money manager BlackRock, says that some of the recent run-up in stocks "can be attributed to temporary enthusiasm and seasonal strength. We expect stocks to experience tougher going in February." One counterintuitive indicator is the VIX volatility index, which is lower than even pre-recession levels, indicating minimal concern about disruptive economic events. That may be lulling investors into a market that's less stable than they realize. "Risk remains for a pullback in February with sentiment readings approaching overbought levels," Bank of America Merrill Lynch warned clients in a recent research note.

There are also more upcoming deadlines in Washington for brinkmanship over the federal budget. Congress recently extended a decision on raising the government's borrowing limit until the middle of May, but it did nothing to resolve the underlying problem of a huge mismatch between spending and revenue.

Meanwhile, $110 billion in annual spending cuts are set to kick in March 1. Investors may be assuming that true to form, Congress will find some way to lessen or delay the immediate pain, yet leaders of both political parties are beginning to warn that those cuts may go fully into effect. If they do, it would cut GDP growth by about three-quarters of a percentage point, according to Macroeconomic Advisers. That alone won't cause a recession, but it will weaken an economy that's already wobbly.

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Shortly after that will come a standoff over funding the government or shutting down non-essential services, which would weaken growth further. Then the debt ceiling deadline will pop up again a couple of months later. Congress could avert these man-made deadlines simply by doing its job and coming up with a rational way to address the $16 trillion national debt, but that's not the way things have happened in Washington lately.

The stock market has learned to cope with dickering in Washington, but it's unlikely to rise much while there's a clear and present danger that politicians could torpedo the economy. The breakout moment could come once (or if) those big policy matters are resolved. The current congressional calendar suggests that could happen by summer—although Washington has a way of dragging out unpleasant tasks.

Once policy uncertainty is removed from the equation, the future for stocks looks brighter. Many economic trends are going the right direction, with the housing market recovering, employers gradually hiring and consumers slowly paying off excessive debt. Europe seems to be working through its own debt problems, with the worst possibly behind the continent. China is picking up steam again and aggressive new policies in Japan may finally end a two-decade slump there. Many investing firms are predicting that the market will reach new all-time highs by the end of 2013.

Investors starting to pile back into the stock market might be setting themselves up for a modest shock if stocks suddenly retreat. The real test will be whether they stay in—or buy the dip and invest even more heavily in stocks. If they do, that may be the best sign yet of a coming rally.

Rick Newman's latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.