Five Red Flags for the New Year

NEW YORK (TheStreet) -- Several red flags have recently appeared on the investing landscape and are worth watching as the New Year unfolds.

Red Flag #1: Federal Reserve Tapering

Many analysts consider the Federal Reserve's quantitative easing program as being a primary driver of the recent powerful bull market. Now that quantitative easing is scheduled to be wound down, worries are growing about how markets might react.

Fretful chatter first appeared last May, when Federal Reserve Chairman Ben Bernanke disclosed that the Fed was considering plans to begin tapering back its bond purchases. On December 18, the Federal Open Market Committee announced that beginning this month, the Fed's monthly purchases of Treasury securities and mortgage-backed securities would be scaled back by a combined $10 billion dollars.

This cut most likely signals the inevitable beginning of the end for quantitative easing. The question for 2014 is now twofold: How will equity markets react to the "draining of the punchbowl" and how will markets react should interest rates begin to climb?

Red Flag #2: Record Margin Debt

Recently the New York Stock Exchange reported record high levels of margin debt for November. Investors have been leveraging up to extreme levels, higher than in either 2000 or 2007, and high margin-debt levels are typically early warnings of potential stock market declines.

Red Flag #3: Shiller P/E at Extreme Highs

Nobel Prize-winning economist Robert Shiller's cyclically adjusted price/earnings ratio of the S&P 500 is currently at 26.2. This is a level only exceeded three times in history: Before Black Tuesday in 1929; at the height of the dot.com bubble; and just before the most recent financial crisis in 2008. Current levels indicate the potential for a significant "reversion to mean" over coming weeks and months as "irrational exuberance" could be unwound.

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