Stock Market and Economic Update August 21, 2011

The past week hasn’t been particularly kind in the stock markets as we saw little follow-through on the previous week’s rally. My upside target of 1230-1260 in the S&P 500 index was not even approached before selling resumed at around 1208.
 
A few economic reports from last week have me a bit more concerned about the possibility of a recession within the next twelve months.  Although the economic leading indicators that I’ve come to rely on from the Economic Cycle Research Institute turned up again this past week, the only components to rise were financial ones, namely the money supply (with the stock market selling being a contributing factor) and the steep yield curve (ultralow interest rates on short duration debt versus higher rates on longer duration debt made possible by the Federal Reserve’s low interest rate policy). Without these two components, the index would have been down 0.5%, which is down three of the last four months.  Weekly unemployment claims came in at 408,000 whereas they were starting to trend below 400,000 in the last few weeks.
 
So the volatility in the market right now is at least partially attributable to concerns about whether a recession is on the horizon or not. If one is not, then the market is undervalued. If one is, then the market is overvalued. So far, the weight of evidence of a recession is still inconclusive, but it appears that institutional buyers are starting to “discount” that possibility as they demonstrate through selling in the markets.  The research I read is split about 50/50 about whether a recession is coming, with convincing cases made on both sides.  My feeling is that we have a bit further to go on the downside if economic factors or confidence measures don’t start pointing up real soon.
 
Accordingly, I am becoming increasingly concerned about the behavior of the markets and the economic numbers coming out lately since they haven’t been particularly encouraging. Accordingly, this past week I increased my clients’ hedges and continued to slightly reduce exposure to equities just to be on the safe side. 
 
This week will be critical since the Federal Reserve Chairman (Ben Bernanke) will be speaking on Friday and will reveal any further measures they may take to ease recession concerns and restore confidence to the markets.  More information about how the Eurozone will handle its debt crisis should help calm the markets.  But based on the market action on Thursday and Friday, it seems that many institutional and retail investors are not waiting to hear what the Chairman has to say or what solution the Eurozone might propose to avoid a deepening debt crisis.  They have therefore been selling and may continue doing so into this week.
 
I will continue to monitor the markets day to day and make further adjustments to portfolios and increase hedges as conditions warrant. Since the market is heavily oversold, we should expect some level of a bounce this week, if only for folks to prepare for any surprise announcement the Federal Reserve Chairman might offer to help propel markets higher.

Bottom line, it’s too early to reach conclusions about whether or not the April high was an important top in the market. If it was, it was unlike any market top of the past 50 years, with both the LEI and market breadth still hitting new highs after the top. When panic selling spreads across the board – good quality companies go down along with the overvalued speculative stocks.  I can say that barring some type of financial Armageddon, I believe the downside valuation risk in this market is far less than in 2007-08. 

My major equity allocation decision is to give this market more time before making any major adjustments. What is needed –more than anything else– is stability and confidence. Only time and stability can calm the emotional extremes and fears, which still come out of the woodwork on a daily basis. But as I’ve said, if the retest (of the S&P 500 index lows of 1100) is able to hold above the lows of last week, then it could provide a strong market base if evidence of a recession does not increase in coming weeks.

Again, please do not take this message as advice to buy or sell any securities; please consult with your investment advisor (or us!) This message is not intended to forecast what will happen in the market since no one (including me) can do that. My objective is to share what I’ve been hearing, reading and researching, the end result of which is one of cautious optimism.
 
Please don’t hesitate to contact me if you need any help with your personal financial situation or investments.  I welcome your feedback and questions always.

Why I Don’t Trust This Rally

We finally strung together three up days in a row in the stock markets today and that’s a good thing. Volatility is ratcheting down and folks are stepping in to scoop up bargains.  Unfortunately, for the first time since we bottomed back in March 2009, I don’t trust this rally and believe that we are headed back to test last week’s low of 1,101 on the S&P 500 index in the short term.  If the market doesn’t hold at that level, our next stop is likely 1060. Let me explain why this rally has a lot to prove before I believe that this correction is over:
 
1.  Other than relieving an oversold condition, not much has changed fundamentally between last week and today. Uncertainties are abound about the possibility of a recession starting or already started (which I don’t believe), how we’re going to deal with raging federal deficits, and the Eurozone debt crisis. A meeting between German and French officials tomorrow will shed some light on how they will deal with the debt crisis in Europe.
2.  The three day rally that began last Thursday has occurred on light volume, reflecting very little institutional participation.  Institutions often wait for retail investors to bid up the market after a severe selloff to set it up for more selling.  The selling has been coming in on very heavy volume while buying is coming in on light volume, a bearish sign.
3.  Consumer confidence, as measured by the University of Michigan survey released last Friday, was at a record low.  These levels have not been seen since the great recession (but do reflect the recent anxiety over the recent U.S. debt ceiling debacle and stock market sell-off last week).
4.  The main stock market sentiment indicators showed an increase in bullish sentiment last week. This is considered a “contra” indicator. After the recent stock market beating, there seems to be more complacency than fear in the markets. Folks are still in “buy the dip” mode. They might have buyer’s remorse if they’re short-term holders.
5.  The kind of technical damage to the markets caused by last week’s sell-off takes weeks, if not months, to repair.  After-shocks and re-tests of lows are the norm after such a severe sell-off.
The positives that point to a better economic environment and stock market include a better than expected weekly jobs report last week, improved July retail sales figures, good corporate insider buying, and more big corporate mergers announced today.
 
While I believe that the markets could bounce for a few more days, unfortunately, I feel that we are headed lower over the short-term. The S&P 500 index closed at 1204 today, and we may even climb as high as 1240-1260 before the markets “roll over”.  That is 3-4% from here, and it’s only an educated guess on my part since 1250 is approximately where the markets fell apart.  I’d like to take advantage of this short-term rise, but only if more volume confirms the move higher.  Otherwise, it’s easy to get whip-sawed in this low volume environment. 
 
This is why I continue to hold onto hedges and have refrained from putting available cash to work at this point.  I’ve continued to selectively cull positions and rebalance accounts to take advantage of the recent strength in the market. Nonetheless, we remain heavily weighted long in the equity and bond markets despite our cash and hedges.  If the S&P 500 index closes above 1290 convincingly, then I’ll re-evaluate my stance, consider pulling in my hedges and invest more cash.
 
But aren’t we investing for the long term? Why should short-term market dynamics control our investing decisions? While we do invest for the long term, it’s prudent to protect capital when the market is in a well-defined downtrend, especially when a near-term recession is a possibility, albeit a remote one.  Markets around the world are factoring in a global slowdown, and the U.S. won’t be immune.  Sure central banks may pull a rabbit out of their hat and stimulate the economy and markets once again, and I’ll be ready for that.  But for right now, unless I see some institutional “power” behind this rally, I just don’t trust it.  As I’ve mentioned before, I expect near-term market weakness until sometime in October.
 
No part of this message should be considered a recommendation to buy or sell any securities, and you should not act on this without consultation with your financial planner or money manager (better yet, talk to us!)  My position will change if the facts change, so I am not married to this position. That could be tomorrow, next week or next month. I don’t have a crystal ball, so my prognostication should not be taken as true fact (I could change my mind or worse, be wrong!)
 
Please let me know if you have any questions, concerns or feedback. I’d love to hear what you’re thinking.