Market Outlook: Have Markets Ignored Reality?

The predictions of the members of the Barron’s mid-year Roundtable discussion over the weekend were in agreement that the March lows of the stock markets would not be broken. This reminded me of one of the famous “Investment Rules” of Bob Farrell, legendary former chief stock market analyst at Merrill Lynch. Rule # 9 stated: “When all the experts and forecasts agree, something else is going to happen.”

Meanwhile, many stock markets yesterday registered their worst single-session percentage losses in a month. Commodities also faced heavy profit-taking, but government bonds rallied and the US dollar strengthened against a basket of currencies. “We could be seeing one of those occasional all-change signals in short-term trends,” said David Fuller (Fullermoney).

Richard Russell, veteran writer of the daily Dow Theory Letters, commented on Monday:

I’m of the opinion that this bear market rally is in the process of topping out. When a counter-trend rally tops out within an ongoing primary bear market, the odds are that the stock market will break to new lows during the period ahead. That means that the stock market will break below its March 9 lows in coming weeks. A violation of the March 9 lows would be a shocker to most investors, and it would be a forecast of an even worse economy coming up.

As mentioned on Sunday, the S&P 500 had recently been mapping out a trading range between 925 and 950, as shown in the chart below. Yesterday’s close of 924 took the Index below the bottom of the range. As stock markets have started to show exhaustion (also seen from the low volume characterizing the last few days’ increases), the odds are that this could be more than a “false alarm”.

Source: StockCharts.com

An analysis of the moving averages of the major US indices shows all the indices still trading above their respective 50-day moving averages, but the Dow Jones Industrial Index has again fallen below the key 200-day line, rejoining the Dow Jones Transport Index. With the exception of the Nasdaq Composite Index, all the indices are below the early January peaks. Importantly, the levels from where the rally commenced on March 9 should hold in order for base formations to remain in force.

Click here or on the table below for a larger image

Based on pronouncements at last weekend’s meeting of the Group of Eight finance ministers, “green shoots” seem to be wilting somewhat, leaving investors questioning whether the recent reflation trade has not been getting ahead of itself.

The “less-bad-than-expected” school of thought is largely based on survey data such as the Purchasing Managers Indices (PMIs). It therefore makes for interesting reading to revisit the historical relationship between the PMI and stock market movements. The example below shows the US composite (services and manufacturing) PMI plotted together with the 12-month percentage change in the S&P 500.

Source: Plexus Asset Management and I-Net Bridge

For some fun with numbers, I have done a regression analysis of the two series, resulting in an R² coefficient of 0.76.

Source: Plexus Asset Management and I-Net Bridge

Applying the regression results to a range of PMI assumptions, the expected changes in the S&P 500 are as shown in the table below.

Click here or on the table below for a larger image

The figures show that a “pessimistic” scenario of a stagnant PMI would result in a decline of 23.4% in the S&P 500 (i.e. an index level of approximately 700). Even a “realistic” scenario of gradually increasing the PMI by 1% per month between now and November would still result in the S&P 500 being 8.7% lower by the end of November. Interestingly, the stock market seems overpriced under all scenarios over the next few months and only reaches positive territory again in August under the “very optimistic” scenario and in November under the “optimistic” scenario”.

And lastly, John Murphy (StockCharts.com) concurs, remarking:

As good as the spring rally has been, I believe the market is still in need of some corrective action (or consolidation) before moving substantially higher. V bottoms are extremely rare. W bottoms are a lot more common. So are head and shoulder bottoms. It seems unlikely that the market will continue to rally in a straight line. More basing activity is most likely needed. And that’s going to require more time.

Comments

[CautiousInv...:]

There are countless studies of market recoveries following a recession and, with the exception of the 2001 experience, market usually retest their lows one or two times.

For a variety of reasons, markets have a tendency to gravitate to the upside but, during recoveries when equilibriums are fragile, markets can easily get ahead of themselves and, then upon discovery, quickly retreat to prior lows.

Jun 16 10:11 AM

[Larry House:]

The market did not ignore the reality of the time, and that was that the economy was not falling in depression AT THAT TIME. All bets are off, in my view, about what that means for the future. I don't trust the March low as unbreachable, and I am not going to try to time the end of this rally. It will tell me when it is over. I agree with all the points that the rally is losing steam, and it could begin a serious retracement at any time. What I think is the most dangerous view is to think that all problems are solved, and we are quickly going to return to market levels of a couple of years ago, and it is time to buy and hold no matter what. That is a dream that could become a real nightmare.

Jun 16 10:18 AM

[whidbey:]

Remarkable correlation in the series. PMI/SP5: Auto correlation? In any case, the Murphy observation about the shape of recovery rallies is historically worthwhile, V shapes are always suspect and to be regarded with caution and hedges.

IF the market retests the bottom of Q1 we will likely see new lows. The impact on European markets will be substantial, so look for shorts across the board, including China. Then longs for the fall.

Jun 16 11:09 AM

[Lilguy:]

Assuming a causative relationship between PMI & S&P500 (see Whidbey above), a more realistic "PMI Pessimistic" scenario--or maybe a "PMI Very Pessimistic" scenario--would actually show a decline in PMI sometime before the end of the year.

My own personal scenario (which I believe is realistic--to use an adjective) is that the PMI will decline a couple of points through the summer & early fall, then rise into the holiday spending timeframe. Here are the results using Prieur's formulation:

Month PMI %SP chg
May 44.5 -24.7%
June 44 -25.9%
July 43 -28.4%
August 42 -30.8%
Sept 43 -28.4%
October 44 -25.9%
Nov 45 -23.4%
Dec 46 -21.0%

In short, using this scenario, stocks are likely to be down 20% (Dec--SP about 740) to 30% (Aug--SP about 650). I'm comfortable with that kind of forecast.

Jun 16 11:43 AM

[Alphameister:]

A very plausible case can be made that November and March were the double bottoms of the latest cyclical bear market (most evident on the NASDAQ chart), similar to the pattern of the 2002-2003 bear-market bottom. I see limited upward potential for the US market from current levels, but a visit to the March lows seems highly unlikely in the foreseeable future.

Jun 16 12:14 PM

[doubleshortetf:]

Great insights from the technical analysis "gurus" Russell and Murphy.

Market is ready for down leg of at least 50% retracement (IMHO breach) to March low. Why? 'Cos all the pundits who thought sky was falling and could not call the "bottom" in early March in unison are calling for green shoot bull market based on "not as bad" and rationalizing every "bad" news as good news and drinking Hussein's (Obama's real middle name) Kool Aid of BS rhetoric and scary deficits.

Next up is down leg and don't discount collapse of USD and inflation and mention of "stagflation" in 2010.

Jun 16 01:22 PM

[Maxe Paul:]

"That means that the stock market will break below its March 9 lows in coming weeks"

Hold on papa bear! I think you will find the word "months" would be a little more optimistic of occurring, But hey it's your call, do you know something we don't? If so please tell?

Jun 16 02:13 PM

[Mad Hedge F...:]

The markets are currently in LALA land. It looks like the worm has finally turned. Hedge funds that rushed headlong into piling on new risk positions as recently as last Friday are now unwinding them today just as fast. All last week the smart money was selling to the late comers, newbies, and wanabees. The Viagra is starting to wear off. It’s time to take short term trading profits on crude (USO), commodities (DJP), all stocks (SPX), emerging markets (EEM), short Treasury bonds (TBT), all currencies (FXE), and junk bonds (JNK, HYG). I love all these things long term, but suffer from a short term tolerance for paid. When the best case scenario is sideways, I’m outa there. Look for decent bounces in risk reducing positions like the dollar ($USD), short dated Treasury securities (CSJ), and defensive sectors like utilities (IDU). It has been obvious to me that all of the good, long term holds were rolling over on shrinking volumes right at 50 or 200 day moving averages, since last month (see “Sell in May and Go Away” at www.madhedgefundtrader...).

Jun 16 02:15 PM

[Andrew Butter:]

Farrell Law #9...well all the experts agreed that from 9th March this was a Dead Cat Bounce Sucker Rally including Nouriel Roubini, Peter Cooper and 95% of SA contributors...including you?

Well done chaps!

Perhaps you forgot about Farrell's Law #2.

Eer Bear...Mmm don't hold your breath!!

Jun 16 02:54 PM

[Fighting Yoda:]

Green shoots, stress-free stress tests etc simply were PR hatchet jobs. Wall Street of course latched onto it – they would do anything to create the next bubble, even a mini-bubble is good enough for them. Banks sold stock, several already under water.

Confidence numbers, Birth/Death jobs etc do not even pass the smell test. The only evidence we see is speculation fueled by easy cheap money provided by the Fed. We all know how this party ends. Commodity price rises is also sending the wrong signals, or being interpreted wrongly. It is simply China stockpiling, China is importing much more commodities than before the recession, but its overall imports and exports are still down 25%+. Is this demand/recovery?

No recovery till housing/unemployment improves – unlikely before 2011.

Jun 16 04:01 PM

[Old Trader:]

I believe it was Benjamin Graham who said "In the short run, the market is a voting machine; in the long run, its a weighing machine". It appears the balloting is over, and very possibly, a big fat thumb is going to start pressing on the scale.

Jun 16 05:07 PM

[Carl Spackler:]

Great stuff!

Jun 16 05:29 PM

[John Lounsbury:]

Stock Markets often run away from present reality, looking for future reality. They are headed for trouble when the future reality envisioned is so far away that there is too much time for buyers' remorse. That is where I feel we are at this juncture.

There may be a recovery, but the investment community will not wait for the recovery to reach the 3% annual GDP growth rate that is currently priced into the market. If that could be achieved in 2010, the pull backs could be secondary (less than 20%). But, if we have an "L" or a "W" recovery, Richard Russell is more likely to be correct than are the unamimous-in-agreement Round Table members.

This is a very good article with a very healthy dose of reality.

Jun 16 10:00 PM

[Market Sniper:]

Great stuff all around! Good article and comments. Nothing gets a trader's blood up than a fierce discussion of UP or DOWN. Setting aside the fact that NOBODY knows what happens next let alone two days, two months or a year from now, purely fun to speculate. My probable scenario: the current pullback will be fairly short and shallow. maybe a tad below S and P 880-900. then a move to S and P 1050 in early Fall. Then it will be Kattie bar the door time. S and P 540ish based on fundamentals. But, being predominately a day trader, I do not worry about all of that and just listen to the market as it sings through price.

Jun 16 10:36 PM

[User 305589:]

good analysis. since i am neither willing nor able to guess future PMIs or stock index tops or bottoms I focus on my individual holdings and how they will do either in a highly inflationary environment OR in a deflationary /stagflationary one. I think right now it is almost certain that anyone of these scenarios will happen. which one of them though, I am unable to predict. Therefore, a portfolio has to reflect imho the possibility that either one of these scearios develops and that means TRUE diversification. A decent amount of (physical) precious metals, some gold/silver miners, cash, some agriculture and oil/gas value stocks and a good chunk of high quality corporate bonds (btw, i don't care for the ratings by moody's s&P or fitch, I only care for the safety of interest and principal). I am pretty sure this portfolio will do quite well in any of these environments. Especially in the corporate bond arena ther are still good values out there (though not as great as 2 months ago). You can still buy 12-17% yields for the next 3, 5, 7 or 20 years with a high amount of safety. I doubt that the stock market will deliver this kind of returns over the next years - except if we get hyperinflation. Which I don't regard as la ikely outcomke - yet. But in that case, the precious metals will hold up well, as will goodagriculture and oil/gas stocks.

Jun 17 07:06 AM

[carey_jim:]

I hate to be pithy again but markets don't ignore reality, markets ARE reality.

Jun 17 02:42 PM

[Albertarocks:]

I think the predictions of the members of the Barron's midyear round table are about as dependable as a three dollar tent... about as true as this quote from a few years back:

"We in America are nearer to the final triumph over poverty than ever before in the history of any land. The poorhouse is vanishing from among us." [Herbert Hoover in the summer of 1928]

And one final note... their prediction is wrong.

Jun 18 12:38 AM