Seeking Alpha
Long/short equity, deep value, registered investment advisor, CFA
Profile| Send Message| ()  

If you've ever been to any sort of live performance theater, you know that as the show is about to go on, or back on, the house lights will start to flash to warn patrons that it's time to get back to their seats. There's usually a stated policy that they flash at a fixed number of minutes before the performance resumes, but in truth it isn't that exact. It could be a minute early, or more likely a minute or two late. That's where we are with the stock market now - the house lights are flashing to take your seats, but the exact minute isn't known.

The April high would seem to be upon us, but I wonder if Tuesday's close of 1597 was the seasonal top. Failed runs to magic levels aren't all that exceptional, in my experience, but the Street does like to climb the last few feet just for the view, regardless of whether it's time to leave or not. There's that sense of saying you've done it.

I tweeted on Monday that 1600 could come the next day, but alas, we came up a bit short. Wednesday's price action didn't materially improve the short-term odds either. But while I still firmly believe a springtime correction is imminent, it might be a minute or two late. Two things to keep in mind (that the market won't forget) are that one, the Fed reaffirmed its present stance and made no steps towards tightening, even adding that it could do more; and two, the European Central Bank (ECB) is meeting Thursday morning.

A 25-basis point ECB rate cut may have been priced into forward markets, but it isn't priced into the euro yet and not fully appreciated by equities. One good reason is that the culture of ECB - indeed, most of Europe's elite - is very resistant to the notion of being pushed around by markets. In American, if you're really brainy and go to MIT or Harvard, you might set your sights on Goldman Sachs. Not so in continental Europe, where the most revered posts involve running government entities of one sort or another (before you snicker, it isn't the worst thing in the world to happen to a country when the smartest people want to be in charge). Accordingly, ministers can be thin-skinned about taking their cues from the rascals running the equities table.

For that matter, most ministries around the globe hate to be told what to do; the ECB may put off a rate hike just to assert its virility. Its former President, Jean-Claude Trichet, might well be raising rates right now if he were still running the show. You know, to pre-empt inflation in 2020. Nobody was ever going to push him around.

There's also the quite valid argument that lowering the discount rate isn't really going to do anything to spur bank lending and/or credit growth in the Eurozone. It won't. Against that, one can make the case that with three major central banks - the Fed, Japan, and the UK - pursuing aggressive accommodation and the EU having easily the worst economy of the group, the ECB should simply get on with it and join the club.

That argument runs into the same obstacle of being seen as not sufficiently independent, but there is another more worthy candidate for intervention - the euro, in particular the euro versus the yen. The latter has been plummeting in value, creating pricing headaches for European exporters, of whom the biggest is Germany. Last week German Chancellor (prime minister) Angela Merkel was virtually apologizing for any more action that the ECB might have to take, a rare step for any EU prime minister. Right alongside was the German Bundesbank (central bank), complaining that not everyone was definitely signed on for unlimited bond purchases. It certainly sounded like the two had been tipped to a rate cut.

In any case, the last thing the struggling EU needs is a stronger currency - even in Germany, where economic data has suddenly headed south in the last two months. The Bundesbank may feel differently about it, but the folks at Volkswagen would be quite happy to see the euro weaken against the yen. Without a cut, the pain is going to deepen. With a cut, the chances of 1600 materially improve.

Turning back to the US, it's clear that manufacturing and investment have gone into idle gear for the time being. The latest ISM manufacturing reading of 50.7 comes on top of a string of regional disappointments, many of them showing contraction, including Chicago, Dallas, Richmond, and Kansas City. The Chicago reading (49.0) was actually better than it looked in terms of new orders and production, and the US automaker sales that came out later should allay fears that the auto sector hit a wall. But the ISM and Chicago readings were weak for April, with the former posting its weakest non-recession April result since 1996.

The more disturbing weakness in both surveys were the employment and price components. They showed significant slowdowns. It's still only a month's data, but pricing is nevertheless a good leading indicator and the manufacturing weakness showed up in the ADP payroll survey: It showed a loss of 10,000 manufacturing jobs.

The ADP estimate of 119,000 April job additions was about 20% lower than the April 2012 posting of 152,000. The ADP and Labor Department (BLS) numbers don't overlap very closely, but the ADP number has been directionally decent of late. The initial BLS estimate for April 2012 was 115,000, so a similar decrease of roughly 20% could result in the second month in a row printing below 100,000 (though March stands a good chance of being revised to back up over 100K). That might not sink the market, but it would put a heavy spin on a string of disappointing economic releases, including the last reports in employment, retail sales, construction, manufacturing and inventories.

I've been featuring charts on trade and capital spending of late, let's look this week at personal income, specifically real disposable income:

(click to enlarge)Read Disposable Income Growth

source: BEA, Avalon Asset Mgmt Co

The chart shows real disposable income (RDI) growth trends since 1970, with the bars representing quarterly year-on-year changes and the line graph representing the moving four-quarter change. One thing that stands right out is the trend since the year 2000, which features a series of lower highs, as well as the biggest drop in the series.

Note as well that the recent data for the moving four-quarter average shows a low about the same level as the 1990-1992 and 1980-1982 recessions (the precipitous drop in 1973-1975 included the Nixon-era wage and price controls). For the last four quarters, the moving average has hovered around 1%, compared to the series average of 2.9%. The latter height hasn't been scaled since 2007, and the post-2000 average is only 2.2%.

That drop in personal income growth coincides with the recent drop in productivity growth, which has fallen to about 1.5% in the years since 2004. Clearly corporations aren't doing as badly, with margins and profits at historic highs, but the problem is more complex than that.

The point is that if income, employment and investment are all weakening to multi-year lows, the outlook for final demand is less than stellar. GDP estimates are falling to the 1% level for the second quarter and even the year, despite the persistence of Street denizens in their annual calls for making it all up later in the year.

What the make-up is supposed to be based on is something that eludes me. As employment growth slows again and the additional fiscal drag (payroll taxes and sequestration) takes root, the notion that housing growth (which hasn't stopped any of the factors from hitting those multi-year lows) or a fall in gasoline to say, $3.20 a gallon is going to revive the economy seems deluded.

All of that said, the stock market can endure long periods of low growth, negative profit growth and ISM readings below 50 without springing a serious leak. Getting the market into serious trouble, below the lower bound range of its long-term channel - about 1425 on the S&P 500, or a correction greater than the 10% zone - will take a genuine recession (which even if it were about to happen probably wouldn't start to be visible before the fourth quarter) or a credit event (bank failures, EU sinkholes, etc.), or a runaway trading spiral along the lines of 1987.

Yet the market is heavily overbought on both an intermediate and long-term basis. Not short-term, so there is still room for one last push skyward even if the most likely result would be a larger give-back afterwards, but the corrective give-back is coming. Unlike March or April, when markets first crossed into overbought territory, we are entering the time of year when these kinds of corrections happen. Don't think that trading algorithms are at all unaware of this tendency - what do you suppose drove the first quarter advance of 2013 into a carbon copy of the first quarter of 2012? Inspiration from Washington?

I was writing back in February about an April high, and we are very near it now. While I still believe that a last attempt to break 1600 is more likely than not, I have also started the process of trimming positions in the last couple of days, and will get more aggressive on any breakthrough or breakdown. It's possible that the market pushes a bit beyond 1600, just to show it can, just because skepticism has increased, but we have moved out of the relatively safe period of the first four months into a day-to-day period. The recent significant trading weakness in commodities and basic materials is sending you a message.

The equity top may be Thursday May 2nd, or Thursday the 9th or Tuesday April 29th; like everyone else, I won't know for sure until afterwards. But between now and the end of June, you should expect the market to make its seasonal move back downward, at minimum to the 200-day moving average (exponential), which is at 1460, and more likely to come to rest somewhere between the 200-day and the bottom of its long-term channel, or 1425-1430. In other words, 8%-12% lower.

In addition, the popular defensive ETFs, the low-volatility S&P 500 (SPLV) or the consumer staples XLP, are astronomically overbought. So is the high-yield JNK. I don't believe that they will provide great hiding places to ride out the bad weather. Although the Treasury ETFs TLT and TIP have both moved up recently, they aren't overbought yet, and the Vanguard short-term bond ETF, the BSV (which I own) has some room left on the upside too.

If you can't bear to miss the top or don't want to sell for tax reasons, consider selling 3-month calls on long equity positions (but only if you know what you're doing). More sophisticated managers might put on a pairs position, such as matching 30%-70% of the value of a long market position like the SPLV or SPY (or mutual fund equivalents) with short positions in the higher-beta IWM (Russell small-cap ETF) or MDY (S&P Midcap 400 ETF). Both yield less than either the SPY or SPLV and will typically perform worse during a downturn. If you're stuck with a limited, quarterly 401K menu, you might try switching to a 40-60 allocation between equities and bonds (but not high-yield bonds) for the rest of the quarter.

Don't frustrate yourself. Scale in and out of your positions, rather than going for broke with one all-or-nothing move. And get started now, instead of trying to time the very last uptick. Bulls make money, bears make money, but pigs get slaughtered

Source: The Spring Correction Is Upon Us