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Beware the dreaded ‘melt-up’ Add to ...

Are you prepared for the market melt-up of 2013?

That’s right, melt-up, a loosely defined term that has gained some traction in recent weeks as U.S. stocks tick higher than even the most bullish expectations. In a melt-up, stocks keep rising and rising, diverging from underlying fundamentals.

At the start of the year, Wall Street strategists were expecting the S&P 500 to end the year at 1,531 – a consensus target that was breached as early as mid-February.

The index has since risen another 8 per cent, and strategists have been struggling to keep up. Today, their consensus target is 1612 – and as of Thursday, the S&P 500 was 39 points above this revamped consensus.

To be sure, this year’s rally hasn’t ignored reality. The S&P 500 trades at a little over 16-times earnings, which is close to the historical average, central banks are in full stimulus mode and the U.S. economy has been generating jobs.

But with the S&P 500 rising for the past six months without so much as a 5 per cent pullback – versus corrections of 10 per cent or more during each of the previous four years – observers are increasingly wondering if stocks are simply rising because they are rising.

Ed Yardeni, chief investment strategist at Yardeni Research, recently remarked that the rally could be “the mother of all melt-ups.”

Michael Hartnett, chief investment strategist at Bank of America, remarked in a note that European investors are starting to ask how far this melt-up can go and how they can play it.

Even though his target on the S&P 500 is unchanged since the start of the year, at 1600, he believes a melt-up can persist for some time, and that European cyclicals are ideal stocks to own if it does persist.

His colleague Stephen Suttmeier, the chief equity technical strategist at Bank of America, is more specific on the timing: A melt-up could send the index to a peak of 1775 in the summer, implying a 7 per cent gain from the current level.

But while few investors complain about rising stocks, the talk of a melt-up isn’t entirely positive. Indeed, it brings with it concerns that investors are feeling euphoric as the bull market’s age stretches to four-and-a-half years, with potentially dangerous consequences.

Just as the bottom of a market comes as investors bail out at any cost, the top of the market follows soon after investors want in at any cost – and melt-ups imply the latter.

“People could be buying just because they are recognizing that they are missing the boat,” said Ron Meisels, a technical analyst at Phases & Cycles. “And that is something that often happens at the tail-end of a major move.”

He noted that stock market newsletters – an important reflection of market sentiment – are heavily tilted toward bullishness right now, to a point that hasn’t been seen in more than two years. The S&P 500 slid more than 18 per cent soon after that previous surge in bullishness in 2011.

For nimble investors who believe they can time an exit from stocks, melt-ups might sound like a great opportunity to score big gains as more investors pile into the rally amid rising euphoria.

The problem is that stocks can also melt down.

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