This is really getting to be a pattern. For the fourth year in a row, or every first quarter since 2010, we are being treated to some crazy momentum rally while being told that great things are happening in the economy. Clearly they must be, or else the tape couldn't be up, concludes the business media, ignoring with a touching constancy the old maxim that the tape makes the news.
One of the larger contributing factors has been the issue of seasonal adjustments. They've either been wrong (Q1-2011) or weather-aided (2012) or just better than hoped (2010). A large part of the media and public gets taken in every time by stories about the economy reaching "escape velocity", yet nominal GDP has been remarkably consistent the last three years: 3.8%, 4.0%, 4.0%. The main variations have been from changes in the price deflator and quarterly swings in expenditure patterns around the central tendency.
The other factor, I would contend, is quantitative trading of one form or another. The first quarter of 2012, which saw an epic double-digit rise in stock prices that capped a six-month run, seemed to cement a pattern of the last three years: buy the first quarter, exit in mid-spring, buy the last quarter, starting around Thanksgiving. The black boxes are now auto-correlating themselves, buying the first quarter almost by default. It isn't required for the news to be good, only that it not be bad.
"Economy Drives Market Rally," said the Saturday Wall Street Journal. Exactly how that road is being driven is a bit fuzzy, the only clarity being that the market is rallying.
Take the January employment report. It's the most seasonally adjusted report of the year, because the count of actual jobs contracts every January by about 2%. This year, according to preliminary (unadjusted) estimates, it contracted by 2.1%, reversing a string of declines in the rate since 2009. The loss was 200K more than the year before, when it was 1.98%, so I don't think any revisions will change the result.
That result dovetails with the recent change in the weekly claims pattern. The year-on-year change in monthly claims had been fairly steady in 2012 at a decline of 10%, but in the last few months it seems to have fallen to 5%, even after factoring in Hurricane Sandy.
The two ISM surveys, manufacturing and non-manufacturing, were also supposed to have reflected strength, but all I saw was that they beat estimates. The ISM manufacturing result of 53.1 was positioned as a big positive surprise, yet it was also the weakest January reading since the recessionary one of 2009. The non-manufacturing survey was similar: the weakest January reading since 2010. More ominous in the latter was that the number of growing industries (8) was outnumbered by the number of contracting ones (9). It's unusual for this time of year.
I read all week that Global PMIs were improving to ten-month or eleven-month highs - or in other words, since last spring. You really must see the chart in order to understand that the trend since 2010 has in fact been a slow fade in the rate of improvement. It doesn't look at all like the globe is reaccelerating, more like praise for want of something better to say. The prior week's durable goods number was revised downward in the factory orders update, and the previous increase in business capital spending for December was revised to a decline.
Weekly sales reports were weak all January. Mark Hulbert reported that insiders are selling stock at the fastest pace in years, which isn't that surprising given the divergence between the downwardly biased outlook provided by corporate management and the upward bias in the stock market.
Yet unless there is an exceptionally weak jobless claims number tomorrow, all Mario Draghi needs do is not show up drunk at tomorrow's EU announcement and put his foot in his mouth over the Bank of Monte Poschi. Then markets are likely to rally at the amazingly bullish development that he didn't shoot himself. Quants are now buying all central bank meeting days that don't produce negative developments. In other words, buy the absence of bad news, and buy harder anything that seems market-friendly.
The economy is, in fact, not doing any better than it has over the last few years. If anything, we are in the midst of another pulse downward. The payroll tax has already crimped spending. The impending sequester will mean more cuts, and housing and autos, while on an upward slope, aren't enough to offset the weakness in spending (70% of GDP), global trade, and business investment.
In 2012, the February slump was avoided by virtue of an exceptionally warm winter. We are getting the opposite effect this year, with the combination of cold weather and financial speculation in the energy sector driving oil and natural gas higher. Higher prices for gasoline and heat (including heating oil) are landing on top of the payroll tax.
The impact of the above headwinds on the market is hard to quantify. The data from these effects mightn't start to cross the tape in a meaningful way until March at the earliest, possibly April. Quantitative trading is buying the quarter until proven guilty (or the latter part of spring), and some retail money is coming off the sideline. Black boxes are going to be supported in their trading by the seasonal bias, which could last through 2014. It isn't yet clear that we will see data strong enough to overcome the seasonal bias beyond a short pullback.
I happen to believe that the odds favor a February pullback, partly because the market is extended, partly because there will be no weather bailout, and partly because the sequester battle is approaching. The last factor is the most critical.
While the markets may be extended, they can stay implausibly over-extended for implausibly long amounts of time. The weather isn't going to bail us out, but seasonal adjustment factors may blur the picture enough to allow the rally to march on. Remember, the news doesn't have to be good, just not incontrovertibly bad. The tape will take care of the rest.
Obviously Europe raising or lowering the curtain on how ugly things really are could matter to the market, but that has been unpredictable all along. The sequester battle could trump all else, starting with the obvious chance of a dogfight poisoning the atmosphere. The outcome to be wary of, though, is actually a deal, any deal, that seems to avoid the worst. The sequester is supposed to lop off $85 billion in spending, but a deal that cuts "only" $50 billion might be seen as a victory by the markets. Not in June perhaps, but good enough for the first quarter. As contradictory as it may seem, any pullback may be fleeting.
I began to fade the rally when we crossed 1500, but lightly. I've been cautious about it, mostly selling covered calls, and in steps. Unless Europe or North Africa intervene with a scare, it's possible that we get to 1525 by the end of next week. We may not have seen the high for the season yet.
If you want to go all in for the quarter, the mid-cap ETF MDY is clearly the big-beta vehicle of choice right now. If you're bullish but not so sure, you could move down the beta scale with SPLV, the ETF that tries to track the low-volatility part of the S&P 500. A reasonable pairs trade would be to go long the MDY and short the SPYder (NYSEARCA:SPY), but if you're like me and want a low-beta approach, I would rather be long the SPY and look to short the MDY. The dividend yield is in your favor (about 2% for the SPY vs. 1% for the MDY) and when the market breaks, the trade should produce decent relative performance.
You can't do that in a conventional retirement account, and pairs trading isn't for everyone. If you feel reasonably certain that the market will finish the year out between 1450 and 1600, then you could sell the SPY January 2014 152 LEAPS, or call options with a 152 strike (if you don't know what that means, don't do it). If the market is below 1450, you will have mitigated your losses, while if it's above 1600, capped your gains.
Do the above as covered calls. So long as the SPY doesn't quickly rise towards 1600, you can also collect the quarterly dividends along the way. I know that some might recommend selling puts instead to capture the premium and enforce buying discipline at a preset level, but I don't. I was around in 1987, when naked put strategies wiped out scads of investors. In my mind, the rise of quantitative and high-frequency trading strategies have increased the possibility of seeing a black swan in the markets.
If neither options nor shorts suit you, you could do worse than simply starting to build positions in the TLT or TIP ETFs as the market rises. You'll get paid a dividend, and they both should rally when equities pull back again. The real trick will be convincing yourself to actually start selling equity positions when it's time - because they won't ring a bell.