The Time For Caution Is Upon Us

 |  Includes: DIA, QQQ, SPY
by: Bret Jensen

The markets continue to march higher and the cheerleaders on CNBC seem to be getting more numerous by the week. There are some solid reasons for the buoyant stock market. Job growth is averaging slightly over 200,000 jobs monthly in the New Year and fourth quarter earnings reports have mostly came in better than expected. The housing market is also showing sustained recovery. In addition, Europe has stayed mostly out of the headlines in 2013. Finally, the sequester cuts turned out to be much ado about very little substance given they amount to less than two percent of overall government spending.

All this has contributed to a roughly ten percent rise in equities to this point in 2013, and several economists have recently raised their projections of 1st quarter GDP growth to as high as 3%. It has been a good run and investors have enjoyed it. However, I believe we are in the eye of the storm and this rally will hit an air pocket just like the "Summer of Recovery" in 2010 and the rough, sharp pull backs in 2011 and 2012 triggered by events in Europe. Given how low volatility and option premiums currently are, investors should buy cheap protection on their long portfolios. There are three main reasons for my pessimism which I believe will lead to at least a five percent decline before the second quarter is out.


The challenged continent has managed to stay on the sidelines and has not caused any major market disruptions in quite some time. Do not count on this lasting for too much longer. The whole continent is predicted to have contracting GDP growth again in 2013. Greece is experiencing higher unemployment and financial hardship than the United States did in the Great Depression. Austerity has not worked and the Greek government has not made the necessary changes to become competitive. Its lenders are again asking for more details on cost cuts before they release the latest tranche of an ongoing bailout package. Cyprus is seeking its own bailout and for the first time it looks like bank depositors will take a hit and Cypriots have predictably reacted by trying to get their money out of these banks. It will be interesting to see what sort of unintended consequences this move will have throughout Europe (Ex, will depositors try to yank deposits out of banks in countries that may need a bailout?). In addition, Italy seems incapable of forming a government and France's PMI is abysmal and shows the contraction is taking hold in that country. This is just a sampling of the litany of woes facing Europe. How long can this continue without major riots and/or credit events that affect our markets again?

Job growth

Before we get too excited about the 203,000 monthly jobs on average over the last three months, we should remember at this point in 2012 job growth in the United States was averaging 279,000 a month. Those average monthly gains then slowed to 117,000 jobs by June 2012. In addition, the February jobs report was not as strong as it appeared on the surface. The number of involuntary part-timers in February came to nearly eight million, up from its recent low of 7.7 million in March of last year. In fact, more part timers found employment in February than the overall increase of 246,000 private sector jobs. This means we actually had less full-time workers in February than in January. This is a predictable and underfollowed consequence of the implementation of the Affordable Care Act. Businesses seem to be hiring part-timers or moving full-time workers to part time work to avoid the fines upon implementation of the policy in 2014. This type of activity should accelerate as we get closer to 2014 and "Obamacare" was even mentioned several time in the latest Fed Beige Book as a hiring headwind by businesses. Obviously if the strong job growth of the last three months slows going forward, that will have a negative impact on the markets.

Consumer Spending

One of the drivers of the market rally of the last four months or so is that consumer spending has held up much better than analysts had expected in the face of the payroll tax holiday expiration, other tax hikes and Sandy. However, I think it is bit early to fully judge whether consumers are going to continue to spend given the current low personal income growth numbers. Hidden in recent consumer spending reports is the fact that restaurant spending has now been in decline for two months in a row. I think this spending malaise will spread to other consumer discretionary sectors soon, probably right after tax refunds are done coursing their way through the economy.

I think investors should chart a cautious course over the next few months.

A) If fully invested, buy cheap portfolio insurance through the options market

B) Underweight the Consumer Discretionary sector given the headwinds to consumer spending and a high probability that the recent strong job growth will not last through the second quarter.

C) If you have or are going to raise cash levels, make a shopping list of stocks that you wish to accumulate if they were to fall 5% to 10%. You might just get that opportunity in the near future.

Be careful out there and Happy Hunting.

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.