It’s been an incredible start to 2013 for equity investors. The New Year rally, which really started back in November, has seen the Dow Jones Industrial Index touch 14,000. That’s a rise of over 11% in just a couple of months, and around 7% since the end of December.

That’s a fantastic rate of growth, and one that makes me a little nervous. Stock markets have already more than doubled in four years, and investors are chasing stocks higher by the day. But am I right to be nervous? Whenever I feel like this, I find it concentrates my thought processes to break down the reasons behind the market move before then attempting to forecast where we’re headed in the months ahead.

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Reasons for the rally

As I see it there are four major factors that have been the main drivers behind the continuing market rally. These have combined to produce a combination of fundamental and emotional support for equities that has proved irresistible to investors, but could they turn out to be the catalysts for a pull back, too?

The Fiscal Cliff

The Fiscal Deal fudge helped take some short term uncertainty out of the market. In truth, however, many spending cuts have merely been delayed. Tax rises, too, though perhaps the effect of the cessation of the 2% tax holiday has been underplayed. Consumer spending could be hit by the average $100 per month decrease in net pay across all consumers.

Europe

For months, the sovereign debt crisis weighed on markets, but slowly that weight has been lifted as the Troika of the EU, ECB, and IMF took measures that released the valve. But I’m not convinced the problems have gone. They’re just hiding. Spain is in crisis and Italy not far behind. The Eurozone economy shrank by an annualized 2.3% in the fourth quarter and both Germany and France are now in decline.

If Europe can’t drag itself out of recession, then the debt crisis will rear its ugly head again, sooner rather than later.

Corporate results

A combination of cost cutting and a weak dollar has kept corporate profits better than expected. Fourth quarter earnings were estimated on the low side, and the surprisingly good earnings numbers have cheered investors.

With nations around the world now eying currency devaluation as the way to promote exports and increase economic activity, the four year dollar devaluation may be coming to an end. When it does, that’s going to be real bad news for the dollar value of the foreign earning of U.S. companies.

The ‘Great Rotation’

As interest rates have been kept low, investors have been tempted by treasuries and corporate bonds. But the return on bonds is now negative in real terms, and this has caused an exodus from bonds into equities as investors have accepted higher risk for higher returns. The yield spread between corporate bonds and treasuries is near an historic low.

Corporate bond prices could be about to melt. But what if interest rates rise sooner rather than later? At the Fed there are now dissenting voices calling for an early interest rate rise, despite the official stand of ‘zero rates through 2014’. The longer we have zero rates, the closer the date of a rise. When that rise comes, it’s going to signal the end of the bull market in bonds and equities.

The risk increases

Equity markets have been politically and interest rate led since the financial crisis a few years back. Tremendous gains have been made, but like Warren Buffet says, when ‘everyone else is greedy, that’s the time to be afraid’. Risk now is firmly on the downside. By the second half of this year, that risk could start to weigh heavily.

What can you do about the downside risk?

If you’ve been invested over the past four years, then you’re going to be sitting on some very healthy profits. The New Year rally that we’ve seen has been fast and furious. Market falls tend to be faster and more furious than rises: as stock prices rise, the day when the market is overvalued comes nearer. I’m not saying that the market is currently overvalued, but there are a number of factors that could easily make it so in double quick time.

Timing is going to be key. The next big test of the market could be the Italian elections in March/ April, and quickly followed by the U.S. debt ceiling negotiations in May. Later in the year we have the German national elections, and in the meantime we’re going to have monthly hurdles of inflation and unemployment numbers to jump.

Investors need to be vigilant and protect their portfolios from a sudden southerly movement in prices.

A combination of 3 and 6 month index futures and options, using calls and puts appropriately is a good starting point. Of course, if you’re happy to sell some stock positions then managed trailing stops will follow any rise in the market while protecting your profits from a crash in values.

Finally, inverse index ETFs will produce profits should the market decline, and can be easily traded on exchange.

In a word, be vigilant. It’s not a question of if a market fall comes, but when. If you are prepared as an investor now, then you’ll be in a position to profit from any fall with cash available to buy stocks when they look a lot cheaper than they do today. If you take no precautions against a market fall, then a decline in prices will be a problem and not an opportunity.

The biggest winner will be the one who gets the timing of the next U.S. interest rate rise spot on. My bet is on the second half of this year.