The Trend Is Your Friend - Until The End

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

As equities endured a daunting correction Thursday - the S&P was down around twenty-five basis points in morning trade - the question only naturally comes to mind over whether to buy this fearsome dip, or to move to the sidelines and wait for something huge, like a one - or even (God forbid) two-percent correction.

Let me pause a moment and confess that I have been a double agent of late. On the one hand, I have constantly been remarking about the contrast between ebullient headlines, equity prices and weak, even deteriorating economic fundamentals. On the other, I have been steadily predicting that equities were likely to continue their march to new highs in spite of an increasingly rickety foundation. Even so, a spring correction would still come.

Now the heights have been scaled - 1600 on the S&P, 15,000 on the Dow. Breakout, or last gasp before Armageddon?

The answer is most likely to be neither. Looking at the Armageddon case first, the nature of the market is that while 5%-10% corrections are commonplace in the second quarter (though not before April is over, or nearly so), collapses and crashes are almost non-existent. They're not impossible, of course, as something like a declaration of all-out war in the Middle East would very quickly demonstrate.

But while no market anywhere is immune to external disasters, the nature of humans and their stock markets is not to surrender this early in the year. Fade or weaken, surely, as the well-known "sell-in-May" paradigm suggests. But not to crash.

Equity analysts will always insist that the market isn't expensive, based upon forward estimates that almost never come true, yet are still four or five months off from being cut (quietly, very quietly). There will be some sort of lucky rabbit's foot-relative metric that someone somewhere will manage to dust off and bring forth for everyone to rub. Even if the killer asteroid was on a direct collision course with the Earth, Jeremy Siegel would be advising you to buy stocks because you never know, it might miss. Then you'd really clean up.

But the breakout scenario is most unlikely as well, and not simply because of the demonstrated prowess of the "sell-in-May" maxim that has been so much in the news as of late, providing a crucial additional worry bead for stocks to finger as they climb (there is no trade more highly coveted on the Street than the in-your-face rejection). The market is overbought in every time frame - short, intermediate, and long (though the short-term indicators are very extended, they haven't quite touched ridiculous).

The impetus launched by last week's ECB rate cut and better-than-expected (though still not good) jobs report was an odds-on favorite to keep going this week, because that is what the stock market almost always does in a news-empty week: It keeps going in the same direction. That, plus the Dow closing over 15,000, has induced a hefty wave of euphoric commentary on the utter inevitability of the people's glorious economic recovery and justly rising stock prices.

That is one of the pre-conditions for a good-sized correction. To get some good action started, you have to catch everyone leaning the wrong way, like many were on Friday when the jobs report surprised to the upside after the rather grim disappointment from ADP.

When prices have been rising, the media puts an endless stream of bulls on parade, throwing in the odd bear or two as unreconstructed crank for the amusement of the masses. It fosters that sense of invincibility. When they've been falling, they rush to the other side of the boat and start taking the names of next-of-kin, while reaching for the usual list of famous bears who, having endured an endless amount of sneering disrespect, rarely lack for details on why the market may never recover.

That said, my informal sampling of traders and managers is that skeptic's capitulation - another important ingredient in the recipe for correction - is indeed growing right alongside complacency. This morning I heard the "great" April job report being enthused about on Bloomberg (the actual emphasis was much bigger). But the jobs report wasn't great. It did beat estimates and wrong-footed many, but had more defects than simply being below replacement rate (somewhere between 200K and 250K a month).

Job growth through the first four months of this year is still lower than last year: 159,000 less, according to the latest BLS data. The workweek shortened. Jobs added were heavily tilted towards part-time work at the bottom of the pay scale, while the economically sensitive goods production sector fell. If you belong to the lagging-indicator school, the composition of the report suggests an expansion in its elderly stages, not its youth (did anyone notice that the bull market reached its 50-month anniversary this week?). The JOLTs indicators (labor turnover) for Q1-2013 were virtually identical to Q1-2012, including the quits rate.

The March retail sales report was weak - the year-year growth in first-quarter retail sales was only 2.8%, the weakest first quarter since 2009, coming on top of the weakest fourth quarter since 2009. The April weekly data were nothing to get excited about. The March wholesale sales and inventories report released this morning revealed the highest inventory-to-sales ratio (seasonally adjusted) since October 2009 and a second consecutive month of negative year-on-year comparisons. The trailing twelve months of wholesale sales fell for the third month in a row.

Perception is everything in the short term, and the decrease in wholesale sales is admittedly nothing in the market compared to a positive surprise from a central bank or jobs report. The point is the fulfillment of an important condition, namely the replacement of fear with optimism based on the tape, while the economic reality on the ground isn't moving in the same direction. You have to disappoint and scare to get a change in direction. As the voices of doubters grow more still and predictions of 25% and-up returns grow, the market's vulnerability to the springtime correction grows.

Even the bears have been muted lately. One trader made a remark I have heard so many times in the past - "well yeah (prices don't go up indefinitely), but they could go a lot higher first." Ah yes, it is definitely coming, and soon.

Though it won't affect the markets much in the short term, if at all, I couldn't help but comment as well on the South Korean decision to cut interest rates. When Japan announced it would essentially devalue the yen, the G-20 got together and agreed to pretend it was something else. Result: Soaring Japanese stock prices and Sony's first profit in five years.

Recently I'd written that one reason the ECB would cut rates last week was to arrest the fall of the yen against the euro. Now we're not supposed to notice that South Korea is trying to weaken the won. As I said, it probably won't matter much to markets right away. But I don't like the direction of this at all, not one bit. If this sort of thing keeps up, the consequences won't be pleasant.

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.