The Goldilocks Market And The 3 Bears

Includes: DIA, SPY
by: Dallas Salazar

I like to write articles for the market investor who still believes in the truth - for the market investor who still believes that the stock market is a complicated system of pulleys and levers that work together like a well made watch, a tightly wound piece of mechanical beauty. For the market investor that is somehow still under the romantic fantasy that the stock market is a representation of the economy, and that they have a fighting chance. I like to write articles that act like the sound from the alarm clocks that wake these people up from their dreams. Wake up. Welcome to reality. Welcome to the Goldilocks Market. In our version of the classic fairy tale the porridge and beds may look a little different, but the risk of the bears coming home is still very much there. This is the story of how this time around Goldilocks can see the bears coming home from a mile away.

For those who are unfamiliar with the story of "Goldilocks and The Three Bears," the fairy tale tells the story of a young girl who enters into the house of a family of bears uninvited and proceeds to take liberty with their porridge and beds. She finds that she's unhappy with the porridge when it's too hot or too cold and that she's unhappy with the beds if they are too big or too small, that she needs them to be "just right," She finally finds comfort in this foreign setting and but a few moments later, to the surprise of our fair girl, the bears come home and she is forced to run away, never being heard from again. Sound familiar? Well it should. Welcome to the S&P 500 Index (SPDR S&P 500 ETF Trust - (NYSEARCA:SPY) and the Dow Jones Industrial Index (SPDR Dow Jones Industrial Average ETF - (NYSEARCA:DIA).

You, your money, your faith in the markets, and the indexes as a whole will be Goldilocks. The economic data will be the porridge and the beds. What about the three bears? The three bears in the current financial markets are QE and the threat of tapering, the economy in general, and finally Japan and its plans to weaken its currency and reach an inflation target of 2%.

The Bull Market That Was

The markets love quantitative easing. They do. It isn't even a debatable question any longer. At one point about eight weeks ago one could have argued that the market was rallying at a historic pace based on what appeared to be slowly (very slowly) improving economic data. The housing market seemed to be picking up, the value of the land these homes were sitting on was increasing in value, employment was getting better, industrial output was increasing, and so on and so on. Things were looking good, or at least brighter than they were. All of this in the face of slowing government spending and tax increases. Sounds good, right? It sure did.

Then the data starting to change for the worse. All of the above mentioned data progressively got worse and worse and some surprisingly worse. Upward data trends were broken, so called experts were adjusting their expectation of future data, and all of the reasons the talking heads were using as the reasons the markets kept rocketing higher didn't seem to make sense any longer. Sounds bad, right? Wrong. Nobody seemed to care. The markets continued to move higher and higher without a care in the world, not even data. Not even the data that indicated the health of the economy now, or the economic picture in the future. They didn't care because they knew their rich uncle Ben (Bernanke) would be there to keep things moving forward, at least they thought he would. Just as when Goldilocks become comfortable in her surroundings the bears came home, and our rich uncle seemed to be wanting to slow the help he was providing right when we became comfortable in ours. The fun had just gotten started when the boys at the Fed hinted that at some point with the picture becoming a bit more rosy that they would begin to slow the QE that had worked so long as the liquid courage for the markets participants.

Which brings us to where we are now. An ecosystem of market participants who are being forced to look at economic picture for what it is, a reasonably important metric of which to base the health of the now dependent financial markets. Only unlike in normal markets, we don't want the data to be anything unbelievably positive. We don't want the data to be anything that indicates there may be systematic risk either. We want it just right. Just like Goldilocks did.

The New Market, Not The Old

So the sobering reality has sunk in. The punch bowl that kept the "dollars flowing and the fun going" is in danger of not getting topped off as it has so many times before. The masses are in a state of wonder. To make matters worse, just as this reality became reality, the effects of all those government spending cuts and those tax increases are becoming apparent. So is the economy not improving? Even with the help of all this easing and government spending prior to the cuts? If so that isn't what the markets want to hear. That means systematic risk. That means the possibility of a double dip recession. That means the real recovery could be years away. Or is the economy getting better and this is a short term drop in data? The market doesn't want to hear that either because that means the inevitable tapering of QE. That means rising rates. That means a bond "bubble" pop. That means losses to everybody who reached a bit further than they wanted to in the search for yield and decided they would give that company with not so good credit a shot for those extra basis points. What we want is for the data either slowly be getting worse or slowly getting better. Neither is what we have been getting. Can't things just go back to the way they were pre tapering comments? It sure doesn't look like it.

Even with all that going on we still might be able to justify to ourselves being in the market a bit longer. That the possibility of the market reacting to less tapering was less of a portfolio bomb than the certainty of owning fixed income and getting run over by rising yields. Even with all that going on we just might, but then our friends from Japan had to go and introduce systematic risk of their own into the global markets.

Japan's market has been on an absolute bull run. I'm talking the kind of bull run you see once in a lifetime. I'm talking until recently up 75% since November, and we're-going-to-plant-our-flag-on-the-moon bull run. Until recently. Recently they have seen more volatility than they did in 2008 during the global financial crisis. Recently their market lost 10% in a two day span. Recently the yield of their all important Japanese Government Bond (JGB's) has skyrocketed to alarming levels. The yield on the JGB more than doubled between April 4th and May 24th. Recently their Yen, of which they are making historic efforts to devalue, has had trouble breaking new ground against the US dollar and other currencies. Maybe all of this is another short term hurdle to overcome. Maybe it isn't. The bottom line is the market doesn't like to see major markets trading as if they were microcap stocks. It reminds people of all those times in the last five years that they encountered global systematic risk. I'm not saying that's what this is, but that's what it makes people think about. Japan finds itself trying to perform stimulus on a historic scale and reach a stated inflation target of 2% while also somehow trying to control yields on debt. That is not a typo. They are trying to raise the rate of inflation but hold the rate of the debt. Something that just cannot happen. What they are trying to control cannot be controlled to the extent they think it can - not too hot, not too cold. We may be at the very beginning of some extremely volatile times in their markets and that would have major global financial consequences. If they succeed in devaluing the Yen to the point that they have set as a goal (to reach inflation of 2%) this would create major competitive advantages for Japanese corporations against their global competitors and at the same time hurt the translation of profits from companies based outside of Japan but with operations in Japan to their local currency from the Yen. Meaning an American company that does sales in Japan would have an unlimited amount of potential damage to net sales as they translate from yen to dollars. If they fail to devalue the Yen we would most certainly see market pullbacks in depth equal to the size of the failure of the devaluation and confidence in the current administration and possibly in the use of easing as a tool to stimulate in general. Not at all good for a bull market.

Are The Bears Coming Home?

This article addresses just a few of the current potential risks that exist in the markets. These are the most important and possibly short term in my opinion. The majority of the market rise has been liquidity driven and policy dependent. At the end of the day economic, sales and profit growth failed to meet expectations and valuations continued to get larger and larger. The markets price to earnings has gone from 13.7 to 16.2 this year and the outlook for economic growth and profits has made little to no progress. All of these happened as a result of the above noted liquidity being provided by the Fed and QE, combined with the non existence of any real short term systematic risk. Both are now in question.

The one asset class that has been used as a safe haven in times of volatility and market turmoil, treasuries, has been itself in a bear market. I do believe that with the introduction of both the tapering and Japanese risks that the equity markets will have to get back to reality. How far the markets fall will be dependent on how severe the possible failure in Japan and how much US market participants believe in the actual economic recovery taking place since 2008. With the markets up roughly 15% at the close on 5/31/2013 I wouldn't think it's too much a stretch of the imagination to envision a pullback in the 10-15% ball park depending on the factors above. At least this time around Goldilocks can see the bears outside the window approaching in the distance. If she hangs around to see what happens this time she'll have nobody to blame but herself.

Disclosure: I am short SPY. 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.