5 Ominous Signs Stocks Could Drop Further

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After the quickest doubling of the S&P 500 since 1936, a number of risks have emerged that could cause stocks to fall lower.Although the S&P is still up by about 5 per cent so far this year, the index has dropped 3 per cent so far during May.

Market watchers point to a number of reasons why stocks could head lower, including the end of the Federal Reserve’s highly controversial second round of quantitative easing, known as “QE2.”

Here are five signs that don’t bode well for stocks:

End of QE2. Part of the intended goal of QE2—in which the Fed is buying up $600 billion worth of treasury securities to help jumpstart economic growth—was to boost stock prices. But after the Fed program ends, experts worry that stocks could falter without the Fed’s stimulus.

“No one knows what’s going to happen after the Fed stops buying treasuries,” says Charles Biderman, CEO of TrimTabs Investment Research. Biderman says this is the riskiest market he’s seen since August 2010, a few weeks before Fed chair Ben Bernanke hinted at plans for QE2. “It looks as if investors are anticipating the end of QE2 and starting to take profits,” he says. He points to increased insider selling—the selling of shares by executives and employees of companies—which has risen to $8.3 billion in May, its highest level since February, according to TrimTabs. That’s about 26 times higher than insider buying. The ratio of insider selling to insider buying typically in the low single digits, he says.

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A stronger dollar. In recent weeks, the dollar has strengthened against other currencies, such as the Euro, and experts say it could go even higher after the end of QE2. The U.S. Dollar Index, which tracks a basket of foreign currencies against the dollar, is down about 4 per cent year-to-date, but it has risen by about 4 per cent so far during May. Some experts say a weaker dollar has contributed to the stock market rally because it helps make the products of multinational companies cheaper overseas, which translates to higher earnings and stock prices. “Clearly, the weaker dollar has been part of the fuel which has driven commodity prices and equity prices higher,” says Richard Ross, global technical strategist at brokerage firm Auerbach Grayson. “Now we have QE2 ending, and the dollar is showing some nice strength.” A stronger dollar could chip away at the earnings of big U.S. companies overseas, he says.

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Weaker economic indicators. A number of recent economic indicators have shown a slowdown in growth, one of which was this week’s Richmond Federal Reserve survey, which showed an unexpected drop in manufacturing activity. “What you’re seeing right now is the market readjusting, recalibrating, and waiting to see economic data,” says Quincy Krosby, market strategist with Prudential Financial. “If you do not get the economic data picking up after this soft patch, the market could pull back.”

Seasonal factors. Historically, the six-month period that begins in May and ends in October is a slow time for the stock market. As summer approaches, trading volume typically trends lower than in previous months. From 1950 through 2010, during the period of November 1 through April 30, stocks in the Dow Jones Industrial Average have risen 7.5 per cent, on average, according to The Stock Trader’s Almanac. In stark contrast, stocks have risen a paltry 0.4 per cent, on average, during the time period between May 1 and October 31.

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Treasuries rallying. Most experts thought treasury yields would rise as QE2 draws to a close, because the Fed is no longer buying treasuries. But the opposite has happened. Earlier this year, the yield on the 10-year treasury rose to nearly 4 per cent. Now, the 10-year treasury bond yields around 3.1 per cent. A lower yield means that investors are once again buying treasuries. “I think that’s a bearish divergence,” Ross says. “It’s telling me investors want safety.”

This post originally appeared at U.S. News & World Report.