Fade This Rally

Includes: DIA, EWG, IWM, SPY, VGK
by: Kevin Flynn, CFA

Let me start by noting that I didn't write, "short this rally." Not yet, anyway, and here's why.

Last week I wrote about the coming bright red move in equities (should I have called it "Big Red?"), but added that there would be a probable rally first if the cliff-dance band started playing. Accordingly, I dumped all of my hedges at the close on Friday and luckily, Monday was the best closing day in history, despite its traditional performance as a boring down day. I then used some of the cash from the hedges on Monday to buy more equities, because if a deal was done, the market would gap higher at 7 AM Wednesday and getting in would be a guess after that.

The point of the foregoing is not to take a victory lap, but as a reminder about the realities of the tape and how it's not good to pick fights with it, especially at the wrong time. Keynes was one of the first observers to write that one can be right on fundamentals and still lose money on the market: Standing alone against the herd tends to lead the phenomenon of being run over. Much of Wednesday's advance was fueled by short-squeezing. In the absence of an alien invasion, a cliff deal was certain to start a rally.

The rally could go on for a day or three yet, despite the algo-driven reaction to the FOMC minutes. It's reasonable to infer from the quite strong ADP payroll number (alright, a relatively strong 215,000) that the Labor Department's jobs number will be good Friday as well. That has a fair chance of letting the rally go on a bit longer, unless the algos are now being reset to interpret good economic news as bad for Fed liquidity. It's possible, though it would be laughably early to draw such a conclusion. However, I don't program the boxes.

If the market should march higher, then I will start selling call options. Personally I favor selling the January 2014 LEAPS, as I don't expect great things from the market this year (neither does Byron Wien, though that doesn't make me right), but others may have more sophisticated strategies. Then I would start adding to shorts and buying inverse ETF positions (only suitable for very short-term trading). Right now XLF and EEM look the most overbought to me, at least technically.

The reasons are three-fold: The political economy, the real economy, and the relative pricing thereof. To begin with, my main thesis from last week remains intact: The debt-ceiling battle is going to turn into an ugly political brawl. In a promising start, House Speaker Boehner has announced he will no longer work one-on-one with President Obama. The extension deal that did pass got barely more than a third of the Republican votes, and everyone is going to be looking for a measure of payback come the debt battle. Boehner and the Republicans are going to want more than Obama will give on the social safety net, and I don't believe that either side will stand down until well after the floor is covered in blood. It will be bad for markets.

The real economy is neither as good as the press seems to think in the many year-end reviews, nor so weak that you need to go all-in short today. Perhaps the key is that it isn't strong enough to trump the coming battle.

The latest ISM reading was a neutral 50.7, while new orders also remained in neutral at 50.3. The tally of growing versus contracting sectors that I like to track was more ominous: seven growing versus nine contracting. The comments were decidedly mixed. For that matter, the ADP payroll report included a decline of 11,000 manufacturing jobs. Fourth quarter GDP is going to decline from the third quarter (note the surprise drop in November construction spending, combined with a downward revision to October). We are going to lose additional velocity in this quarter from the expiration of the payroll tax cut and the confusion and hesitation induced by the debt ceiling battle. The latest US leading indicator read from the Philadelphia Fed was a slight decline to 1.4%.

Then there is the weather. Last year we enjoyed one of the warmest winters on record. It's going to mean tough comparisons this year, especially if the usual practice of giving the greatest weight to the most recent year is followed in calculating seasonal adjustment factors. Last year's weather-fueled "escape velocity" song turned out to be sung by sirens. This year may produce an opposite effect, though it will be mitigated by the usual Street practice of underestimating the numbers.

That goes for fourth-quarter earnings too, which kick off with Alcoa (NYSE:AA) next Tuesday and Wells Fargo (NYSE:WFC) next Friday. While I expect decent results from the financials for the last quarter, the ongoing recession in Europe is going to be brought back to mind when the larger S&P 500 companies start to report in earnest the week after next.

There is no reason to expect that underestimation will fail to produce the usual percentage of earnings "beats," yet it's going to be a weak quarter for earnings growth nevertheless. Companies are always optimistic about the second half at this time of year, but global companies are going to have a difficult time thinking of good things to say about the current quarter. More likely is that we are going to hear a lot of blame on Washington, which should only further help the debt ceiling process.

Coming back to Europe, I am still scratching my head over a sentence in the December 24th edition of Barron's that proclaimed Germany to be "Europe's standout economy, an economic engine firing on all cylinders." Germany just reported the 10th consecutive month of manufacturing contraction and unemployment growth. This is all cylinders? I don't like to call out other publications, but the reason I do so in this case is to illustrate my point about relative pricing, because Barron's has plenty of company in swooning over Europe as the next big thing.

Which brings me to relative pricing. Others may argue about multiple expansions and corporate bond models, but a hard fact is that the S&P 500 index was closing in on a multi-year high Thursday when the FOMC minutes spoiled the party by revealing that a few pusillanimous members had been wringing their hands over Fed money-printing. This market is not priced for bad news. Despite Germany's slip into recession, its DAX index was up 29% in 2012 and is at a five-year high.

The ancient tradition of rigging estimates is still with us, but earnings are not going to be a fundamental driver for good. At best earnings will be neutral, at best the economy will be neutral, and at best the political scene will not result in outright riots.

I'll repeat: Watch the tape. There are reasonable grounds for the rally to have a bit more steam, not least of which is momentum and the desire to punch through to marginal new highs. The main part of the correction may not start until earnings season is nearly over (a common phenomenon), but there's some chance it will start earlier. As we head into February, Washington will get hotter as earnings and the economy get cooler. Therefore, you should be looking to exit and/or hedge anything that looks extended and be willing to sell into strength, in particular marginal new highs. All we need is another percent or two higher between now and the end of next week, and sentiment and prices will be perfectly positioned for disappointment.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Problem with this article? Please tell us. Disagree with this article? .