The First Bell Has Rung For Equities - Part 2

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

Let me begin part II (see part I here) by addressing the short-term outlook. Wednesday was a good-sized pullback, but two of the previous three days were new all-time nominal price highs for the S&P 500. Much of the selling is probably due to the first quarter: the media may talk of traders trying to protect profits, but after a big first quarter like the one we just had, some significant quarterly asset reallocating is bound to follow. Last year's big 12% gain in the S&P led to a similar sell-off in stocks as institutions re-weighted, pulling the average down briefly below its 50-day exponential moving average (EMA) before it rebounded.

The current 50-day EMA on the S&P sits at about 1527, or a bit less than two percent away, with the 1520-1525 appearing to be some sort of probable area of support. That's only about three percent from the recent intra-day high, so it really wouldn't amount to much of a correction. It may feel like more to a market where a half-percent down day has been rare and a two percent pullback not seen since December. The 50-day has run far ahead of the 200-day EMA (1448), and is now in a region more vulnerable to a pullback.

One catalyst could be the April jobs report on Friday. Although the ADP report was a big miss of the consensus (158k vs 205k estimated), last month's ADP number was 50k short of the Labor Department's (BLS) number. Were March to be similar and the BLS number to come in at 200,000, that would in theory meet the market's current consensus and probably beat it, since some strategists will cut their numbers in the next day to help the report along.

At the same time, 200,000 wasn't really the market expectation for March. That was closer to 230,000, with guesses circulating of 300,000-400,000. The latter have probably been retired at this point, and the ADP number further suggests that the weekly claims numbers I've been fretting over may indeed have been understated.

Clearly, there is still risk of a miss, and that would weigh upon an already-skittish market, especially if Thursday morning's jobless claims number moves up again from the prior week, adding to the anguish over the ADP number. That said, unless North Korea does something stupid(er), my guess is that the market would rebound from a run at the 1525 area and move back up as it approaches earnings season, the way it usually does in April. Next week features Fed minutes and the March retail sales report, and they could well provide a catalyst, especially as the latter will have Easter-related sales to boost it.

There is also the possibility that the European Central Bank (ECB) will pull an interest-rate cut out of the hat Thursday morning, or that its president Mario Draghi will make another boast about the ECB's unshakeable resolve, in an effort to steady markets. Although I have speculated that there are good grounds for the former, the recent history of German opposition would seem to make it less likely.

Past April, I think that the markets will complete the second leg of a correction in the ten percent range. There are several reasons for this. One is the current state of economic data: the Chicago PMI and the national ISM surveys (manufacturing and non-manufacturing) all turned in their lowest March numbers since 2009. That's consistent with the long-term slowdown in durable goods investment I featured last week.

Another is that the seasonal adjustment factors will begin to reverse, as Bill King of the King Report, among others, has been tirelessly pointing out. Thus, program trading, which has dominated the market the last couple of years, will begin to flip over as well. The default program action in the first quarter was to buy, but that's over. Sometime in May the sell switch will start to get priority.

First quarter earnings estimates have been steadily lowered as well. Even so, you should expect the usual two-thirds beat rate, the usual gushing in the media, and a quarter that has an overall growth rate of a few percent in net income (earnings per share might be a bit higher). That alone won't make the market correct, but it doesn't provide much of a reason to counter the late-spring sellers, either.

But it should only be a correction, absent a big event from the usual list of North Korea, the Middle East and the EU. The bell for equities is ringing for a different reason.

Consider the 15-year weekly chart of the S&P 500 below, with the channel lines I added:

Click to enlarge

It suggests a couple of major points. One is that the index is clearly now near the top end of the channel. You can quibble over the exact location of where the lines might be, but we're still near the top, ripe for a pullback. Note as well that a 10% pullback would take us near the bottom end of the range, at around 1400.

Then consider that the big corrections since 2000 haven't gotten traction until the indices finally managed to pierce the bottom of the range of their upward trends. That makes the exact bottom end of the range of more interest, and you can make a case for various levels between 1350 and 1400, with the precise right answer being wherever the most money thinks it lies. That's the danger zone, and I don't think we'll get there quite yet. I think it will happen later, most likely in the fall, but sometime between the end of the third quarter of 2013 and the end of the first quarter of 2014 (for some traders that may as well be 2050).

Despite some of the foregoing, the risk isn't really the economy or earnings. In 1998, the S&P rose 28.4% even while corporate profits fell by nearly 15%. In 1989, profits fell by 1.6%; the stock market was up 31.5%. Earnings aren't enough, and neither is the economy: in 1991, real GDP fell by 0.2% as the stock market rose 30.2%; in 2002, the former rose by 1.8% while the stock market fell 22%.

The usual catalyst for an equity seizure isn't earnings and isn't the economy, but a credit market seizure. The only crash that I can think of since the sixties that wasn't brought on by the credit markets was the tech wreck, and the earnings multiple for the "new era" S&P lingered at an impossibly-high forty-plus times for many months before finally capitulating (and even that was brought on by investment money finally drying up).

The political grandstanding about gold that is going on in places like Germany, Switzerland and Texas is a warning sign that things are not all well in the confidence department. I would not say that it's another sign of Armageddon, as some would have it. It is a sign, however, of the general stress and fractures that are afoot and will eventually leak into credit markets. Such an atmosphere leads to missteps and delay in confronting the inevitable. In particular, Europe has taken a significant step down the road to ruin in Cyprus.

I want to be clear: I'm not predicting the breakup of the Eurozone, though some fragmentation is conceivable. What will happen post-Cyprus is that "some bank somewhere," as Bill Fleckenstein put it, is going to fail and set off a chain reaction of a loss of confidence in the fixed-income markets. Its nature will probably be between the 1998 currency crisis and the 2008-2009 crash (you know what they say - history doesn't repeat itself, but it does rhyme).

The European economy is a mess and is going to get worse, as you can see from the latest round of PMI and unemployment data, or this survey in the German daily Der Spiegel. In another article in Der Spiegel, Jeffrey Stacey observed in relation to Cyprus that

Despite a final deal that preserved the bank deposit guarantee, the genie has escaped the bottle. And once genies are out, they don't go back in. Installing a banking union has become much more difficult as a result.

This is where I agree with Fleckenstein, who is something of a perma-bear. Fleckenstein also believes that "markets are drunk," and there I disagree. They're ahead of themselves, certainly, and not very good at discounting poor outcomes. But you shouldn't presume that markets only follow earnings growth and economic growth, because it isn't true. Stock markets are above all auction markets that follow momentum first, and the chances of making a winning trade second.

The prevailing belief of what makes up those chances isn't the same from decade to decade. In the era of ZIRP, cues are based first on central bank posture and the hope of the next central bank posture. So long as it appears sufficient liquidity is on tap, then it's about recent trading patterns, and trying to infer what other programs are concluding about trading patterns. The rise of programs that analyze news feeds means a heavy dose of seasonal trading, along with programs that try to anticipate other programs.

Unless there's a credit event, and then it's game over. Cyprus is the crack that leads to a credit event. Whether it's Slovenia, or Greece, or Italy, I can't say. It might be a small bank in Spain. It might be a widening imbalance in the already lopsided "Target2" EU inter-bank payment system. It could still be Cyprus, if it turns out that so much money already leaked out that they have to redo the agreement again. It probably won't be someplace like Deutsche Bank (NYSE:DB), because when its existence is finally threatened, Berlin will act, just as our own Fed waited to act in 2008 until Goldman Sachs (NYSE:GS) was a day or two away from going under.

Until Europe confronts its debt problems with a real solution instead of another bandage, the global economy can't get traction. But until the markets start to crash, Europe won't do more than minimal, last-minute disaster-aversion programs, much like our own Congress over the last several years. Under ZIRP, the global economy hasn't really mattered much, and the Europe recession hasn't either: Some nominal growth somewhere, along with the promise of unlimited central bank intervention, has been enough to keep the money river flowing.

The problem was sort of contained, but Cyprus has cracked the containment vessel. It's been steadily eroding under the weight of recession. The final split will probably come as a surprise, the way it nearly always does. You probably don't need to be reminded of our own Ben Bernanke saying that the sub-prime mortgage problem "appears to be contained," but have you seen the Cyprus Central Bank's February denial of the mere possibility of going after depositors? Here it is, courtesy of ZeroHedge.

This isn't a US-based problem, and that's what confounds many. We could do more, certainly, but the US has already done enough restructuring to generate real GDP growth of 3%-plus - if Europe were running at even 1%. But it isn't, and it won't until it restructures, and it won't restructure until it starts to crash. I happen to think that the most likely time is in the fourth quarter, but you can never tell that far ahead. Watch that lower bound.

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.