A Back of the Envelope on the Pullback

I've been concerned that the mega caps haven't participated in the rally, and their playing catch-up will in fact drive the market higher (even as we get a rotation out of smid caps).

Consequently, when you look at the Naz and S&P 500 I'm not expecting them to fall too much. Doing a back of the envelope of the major indexes:

* 50%+ of each index is comprised of stodgy mega-caps trading at an average of about 15x forward earnings (even when you include Apple and Google and Amazon).

* It seems obvious to me that the large caps are undervalued relative to the smid caps. Smid caps are trading at roughly 18x forward earnings (and that might be understating it).

* When the "risk on" trade expires and the "risk off" trade returns, it is easy to see a little pullback and rotation along the following lines. Large cap multiple compression from 15x to 14x (6%-7% decline), smid cap multiple compression from 18x to 15x (16%-17% decline)....translates to a 10% market decline (assuming a 60/40 large cap/smid cap breakdown - in fact the breakdown is closer to 88/12).

In the absence of any serious weakness in earnings (and the economy), it is highly unlikely that we will see much more than a 10% correction, unless PEs were to compress due to some major risk factor.

We need a pullback, BUT...

In my opinion, the market needs a pullback, BUT this is a buy the dip market.

I don't think we're going to see a 20%+ decline, however much this would cleanse bullish ardors. If we're lucky, we'll get a 10%-15% correction, then it is off the races again (maybe not quite the races, but a 1200 target on the S&P 500).

The time to sell this market will be when the authorities try to pass the baton from the public sector to the private sector. That is not likely to happen before the middle of 2010 for monetary authorities and may never happen on the fiscal side of the ledger (just a little tongue in cheek). The critical point will be to anticipate when the market is going to get antsy about the transition (it may be six months beforehand, it may be longer or shorter).

Note: Geopolitical uncertainty brought about by an attack on Iran by Israel, a large terrorist attack on US soil, or heightened trade tensions could throw a spanner in the works.