When I wrote last week that it was safe to sell, I should perhaps have checked the options tables first. Although the S&P index options that are favored by the institutional set were heavily tilted in favor of calls, the options on the SPY ETF were massively imbalanced in favor of puts. Over two million put contracts by my count went to zero last Friday after two little sudden pops in the SPY out of nowhere - one Wednesday morning, one Friday afternoon at about 2PM. Okay, so maybe the pops weren't out of nowhere (details on my website).
Nevertheless, I sold the last of my unhedged SPYs Friday, and have no regrets. I do expect that yesterday's big reversal - from up 155 on the Dow to down 85 - is the beginning of the spring correction, though I don't believe it will be straight down. The market will make at least one attempt to recover this week and may yet finish in the black. Hopefully, some of the lunacy was blown off with the foam, and believe me, that is better for the markets than otherwise.
F. Scott Fitzgerald, whose capture of an American ethos in The Great Gatsby has again been mounted on the screen, wrote that "an artist is someone who can hold two opposing viewpoints and still remain fully functional." The market must be a fine artist then, because it seems that all I read and hear about from fund managers is that the economy is getting better, and the Fed doesn't dare to let up with growth at only two percent. Why the Fed would not let up in the second half as growth accelerates - for the conventional belief is that growth surely will - is one of those marvelous contradictions the Street is so fond of.
According to the Wall Street Journal, Goldman Sachs strategist David Kostin calibrated the firm's hike of its 2013 target for the S&P 500 to 1750 (from 1575) not as a cynical exercise in marking-to-market, but because of a "valuation readjustment," explaining that "one of the biggest reasons for that is the extremely low-interest-rate environment." That's a rather belated discovery by Mr. Kostin, given that the current zero-interest-rate policy is now over 4 1/2 years old. Wasn't former Treasury Secretary Tim Geithner on record as saying, "these guys (Goldman) are really smart?" Yet there is Mr. Kostin saying that rates will not increase until 2016 at least, while his firm maintains that GDP will be "above trend" next year. Now that's artistic.
Like all Street marvels, the contradiction will finish up in a ditch, but in the meantime there is the important business of making money, and everyone knows that it can take quite a long time for the money river to move on to a more inviting prospect (or simply panic and run away). Or for the buyers to realize they've been stuck with another lemon.
There are always plenty of hints along the way. The Fed may raise rates, for example. The classic, almost genetically programmed reaction on the Street to the first rate raise is a sell-off of one day or less, followed by a massive reversal on the theory that with the Fed on the job, the economy has been saved again. If you stuck to the approach of selling every marginal new high until the bottom of the ensuing recession, you would do quite well.
Understandably, the Fed tries to minimize the damage to financial markets from any tightening bias by offering lots of hints along the way. While those of former Chairman Alan Greenspan were infamously opaque, current Chairman Ben Bernanke has striven for an approach of lots of transparency and communication, even giving regularly scheduled press conferences. Under Bernanke, the Fed minutes have become much more revealing, which is not something the stock market always appreciates. For example, yesterday (Wednesday) when the minutes revealed certain mad fools were talking about dialing back on adding a few more trillion to the balance sheet. Saboteurs!
Bernanke knew what was in the minutes of course - besides the little matter of having actually chaired the meeting, he gets to see them again before they're released. It isn't far-fetched to suppose that the dovish tilt of his Wednesday morning speech was in part deliberately meant as a firewall against the release of the minutes. Not that the latter were so disturbing, but even Bernanke, who has never been at risk of being characterized as having the mind of a trader, can read the papers. Every day there's been some new record set by equities for trading up non-stop (like being up 19 Tuesdays in a row); anyone on the Fed's board of governors could guess that an increase in talk about easing up on QE would take a chunk out of a tautly over-stretched stock market.
Indeed, said market has become a two-edged sword for the Fed. On the one hand, its recovery did add to confidence and enables credit to flow better. On the other, that recovery enabled governments everywhere to run at stall speed on making any difficult choices that might damage individual re-election chances. That's caused a lot of harm, particularly in the half-speed confederacy known as the European Union, and of late lent a touch of ninny-euphoria to stock prices.
That works against the main mission of the Fed and its chairman, which is to keep the economy from going off the rails. But monetary policy is only a cushion, not a bulletproof vest. The rise in the stock market not only keeps our own legislators sitting on their hands while they dream up names to call each other - hopefully in front of television cameras - but runaway rises aren't what the Fed wants either. They create crash conditions, as the last dozen or so years has very amply demonstrated. It's been a vicious circle - Bernanke keeps his foot on the pedal because of the impasse in Washington, which stays gridlocked so long as Bernanke keeps his foot on the pedal.
An example of the market's current frame of mind can be found in a piece from MarketWatch exclaiming that "Bernanke Blew It" when he replied during the Q&A that the rate of bond purchases could slow in the next few meetings. How to ruin a 155-point gain in the Dow, bemoaned the article. What about your trickle-down medicine?
That brings up a fine distinction embodied in a worthwhile Bloomberg interview with money veterans Harvey Eisen and Craig Johnson. Johnson pointed out that the weakness in results from chains such as Target (NYSE:TGT), Lowe's (NYSE:LOW) and Wal-Mart (NYSE:WMT) shows how "the consumer is very weak" and that "Main Street is not doing well, and Wall Street is doing great." Eisen agreed that the current situation presages a Gatsby-like ending (see his other interview as well), while qualifying his view with the wry remark that when predictions of a bad ending don't come true in a day, the author is apt to be immediately dismissed. I can sympathize.
So the Fed remains in a difficult spot. The members are very aware that two bubbles, followed by punishing crashes, have occurred within in the last fifteen years. That's after a record of two in the first fifty years after World War II. While the Fed certainly isn't against a rising stock market, the last thing it needs is another euphoric runaway that brings on the third crash in less than twenty years. Today I listened to a conference call for advisors from a firm that advised that the bull market has plenty of legs, based primarily on two things - all the suckers aren't in yet ("there is still caution in the retail public") and "don't fight the Fed."
While I'm reasonably certain that no Fed members sat in on the call, that kind of stuff is hardly an isolated opinion. The New York Fed has to have raised an eyebrow or two at the recent goings-on in stock prices. Taking the Manhattan-centric, Gatsby-esque view, the Bloomberg interviewer who spoke to Eisen and Johnson insisted that the economy is finally getting better, despite the two men telling her it really wasn't, despite corporate profits being negative year-on-year in the first quarter (-1.1%) for the first time since the recession ended, along with quarterly S&P 500 sales growth being slightly negative, and despite the weakness in all manner of things that I cited last week and that were embellished this week by the latest Chicago Fed National Activity Index (a geek favorite), which fell more steeply in April (-0.53 vs -0.23 in March) and has its 3-month moving average in the red for a second month in a row.
The attitudes of the Bloomberg interviewer and the shall-remain-anonymous sponsor of the conference call I referenced above may not be the soundest when set beside hard data, but they are nevertheless in the majority and will not be easily dislodged. Wednesday's sell-off may have taken the indices out of extreme short-term peril, though they are still significantly overbought on an intermediate and long-term basis, but traders are a long, long way from being convinced it's over. They are still keeping an eye on the exit door, but now they're also keeping an eye out for the rebound.
I would stay defensive and beware of false starts. I do expect that the market will continue to trend irregularly downward over the next couple of weeks, with the eventual size of the spring correction most likely to be decided by the June employment report two Fridays from now. But the market won't crash on its own, not at this time of year, and I'm not going to exit equities completely. It won't hurt to raise some cash on the first couple of rebound attempts.
In the meantime, Mr. Bernanke may want to consider having his fellow governors give less speeches, rather than more. It's gotten to the point that the market rallies when a governor simply fails to mention tightening, the way high-beta stocks will rally when they announce an earnings release without an accompanying warning.
He may also want to consider that the longer the Fed goes on with unlimited QE, however well-intentioned, the more Gatsby-like of a situation we will find ourselves in. That's a current I'd like to do without for as long as possible.
Additional disclosure: My SPY positions are all hedged.