The market Friday completed its seventh straight week of gains. It is the first time since 1967 the market has started off with gains in the first seven weeks of a year. However, signs abound that this rally is getting tired and is overdue for a correction. Breadth is narrowing and there are numerous signs of trouble on the horizon.
Headwinds for consumer spending
Consumer spending makes up 70% of the United States economy and there are several reasons to be concerned that its health is deteriorating. Emails inside Walmart (WMT) stating the retail behemoth is experiencing the slowest sales start to a month in seven years caused a decent sell-off in late trading on Friday. I believe it is early proof that the expiration of the payroll tax holiday at the end of 2012 is starting to bite. This expiration took $120B annually out of the pockets of taxpayers and it is overly optimistic to assume this will not contribute to a significant slowdown in consumer spending. High gas prices, which recently recorded the highest level for the month of January on record, are not helping matters either on this front. Delays in IRS refunds compared with previous years are another short term hurdle that will need to be overcome. The break in the Consumer Discretionary Index after the Walmart news (See Chart) broke Friday is a preview of things to come as more signs come in that consumer spending is indeed slowing. I am deeply underweight this sector until we have a significant decline or confirm that consumer spending can withstand the headwinds described above.
We can't fight the world
Over the last two weeks even as our market has rallied, stock markets in other major economies such as China and Germany have turned down (See Chart). In addition world trade is slowing. Exports from Germany and Japan declined and overall world export growth was negative in 2012. China and the United States bucked the trend but export growth for both were slower in 2012 than 2011. To be exact, export growth in the United States was 4.5% in 2012 after being up almost 16% in 2011. Boeing's (BA) recent problems with the batteries on the Dreamliner will not help this metric given it is the country's largest exporter. Budding currency wars as central banks try to inflate their way out of debt and make their exporters more competitive are not helping things.
Politics as usual will continue
A good portion of this recent rally occurred after the fiscal cliff was averted and we kicked the debt ceiling talks down the road. Unfortunately, raising the debt ceiling remains on the "to do" list and sequester cuts of $85B start to take effect on March 1st. Usually $85B in spending cuts on a $16T economy should have minimal impacts especially given government spending will still be more than $1T higher than it was in 2007. Unfortunately, these are not normal times. Given comments from Republican leadership and the strident tone of the President's recent State of the Union address, I don't see any compromise happening and these cuts will probably occur. This will further undermine consumer spending and negatively impact job growth. I also believe the low volatility in the market since the fiscal cliff deal is unlikely to continue for much longer.
Market rallies in 2010 (Greece), 2011 (Europe), and 2012 (Debt ceiling talk collapse and lowering of U.S. credit rating) were all short circuited causing significant declines. Economists believe the sequestration will result in economic growth being reduced by .5% to 1%. Given we had no growth in GDP in the recent fourth quarter GDP report and growth is projected to be less than 2% for 2013 even without these cuts, the economy and the markets are highly vulnerable yet again. Investors who do not have significant cash in their portfolio should consider raising some on the back of this rally and get prepared for a lower entry point after a highly probable pullback. For my own portfolio, I will continue to position myself for the stagflation I see in the pipeline and described in a recent article.
I don't anticipate the market collapsing as long as the Federal Reserve continues to provide extraordinary support to the equity and credit markets. However, I would be surprised if we do not get a 3% to 8% decline in the market in the months ahead. I also believe the indexes have already had at least half their gains for the year in the first seven weeks of the year. S&P 500 profit margins are already at historical highs. The market is also priced at 14x the approximate $110 in earnings that is the current consensus S&P earnings for 2013. It is hard to imagine a significant rally from here in an economy that is muddling along at just over stall speed and with decelerating global growth. I would love to be surprised by better than expected economic growth in the months ahead, but the last few years have showed GDP growth estimates moving lower as the year moves along. Maybe in 2014, when the CBO currently forecasts over 3% GDP growth will be the year that the economy finally recovers to trend growth.
For history buffs, as stated 1967 which was the last time we had seven weeks of gains to start a year. This turned out to be the start of a 16 year period where stocks ended at the same level as they started at when the bear market finally ended in 1982.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.