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The market is right in synch with the calendar this week as it makes a classic sideways move in the third week of the quarterly reporting month. It's actually down the last two days after the first two attempts to breach the magic 1700 number on the S&P were rebuffed. I have a rule of thumb that the first two attempts are always swatted away, and while I wouldn't bet my life on it, it doesn't often disappoint.

Volume has been light as traders ready for next week, in theory the last big one before the Hamptons fill up for the month. It's one of the heaviest calendar weeks the market ever gets, and while I don't keep score of such things, it feels like the most packed one of the year so far. When you consider that the two big manufacturing PMI surveys, the Chicago survey and the national ISM, are (in reverse order) about 4th and 5th in importance next week, that should give you an idea of how charged it is.

All or most of the data will be viewed through the lens of potential Fed reactions. The correlation between the expansion of the Fed's balance sheet and the rally in equity prices has been running in the neighborhood of 90%, and the recent taper-talk episode that began in May made it abundantly clear that short-term market direction is dependent on Fed policy. Its statement will be followed by the second-most important report on Friday, the employment situation.

Last week's column invited readers to speculate on the meanings of Fed policy, and I was pleased to see so many considered replies filling a lively discussion. Given how difficult it is to get individual policy decisions right in advance, I'm going to stay with the general view on next Wednesday's move - the Fed will probably mark time until the September meeting, giving us another seven weeks to speculate about where policy really means to go.

Next week's data should have something to say about it. Recent estimates for second-quarter GDP have been huddling around 1% or less, leaving open the somewhat comic possibility of the market rallying on a print of 1.2% (annualized, and down from 1.8% in the first quarter). It's reasonable to assume that only an outlier result, such as a negative number or an implausible 2%-plus number would move the Fed off a desire to stand pat until a September meeting that will come with updated outlooks, a press conference, and by no means least, the financial elites back at their desks. The FOMC will probably be mindful as well that the first quarter GDP estimate started out at 2.4% and came down steadily afterwards.

I also wrote last week that you should start thinking about what stocks you might want to sell, and I reiterate that advice this week. It's clear from the tape action the last couple of days that some aren't waiting around to start taking profits, even after a positive surprise in new home sales that would usually result in a lot of green lights.

I'm not making a call on August yet, but the month does start out weak more often than not. The last couple of days have relieved some of the overbought pressure on the indices, so if we continue with a light sag the rest of the week it's possible that we will enter August in a more or less neutral position, give or take a little either way. Be warned, however, that the late July sag sometimes gives way to a bigger one that lasts into the middle of the next month, when the robots decide things are oversold and start buying again (and the rookies subbing on the desks are only too happy to go along).

The Chicago Fed's national activity index came out this week, and while both the current and moving-average (3-month) values improved, they were also both negative for the fourth month in a row.

(click to enlarge)

source: Chicago Fed, Avalon Asset Mgmt Co

Looking at the chart above, the last time that equities took off so aggressively as activity was slowing was in the latter half of 2006, when the concepts of "global growth" and "decoupling" were going to safeguard the rally that had begun about four years earlier.

We all know how that worked out, but it's also useful to keep in mind that it took about 15 months for the fade in activity to catch the attention of stock prices. It looks as if we're in the same 15-month region now in a rally that's now about 52 months old, but things are never exactly the same. Markets don't usually hit a calendar peak in July, for one thing, and activity was briefly positive over the winter, probably due to Hurricane Sandy but even so. On the other hand, looking at the last three months doesn't make you want to take the over on the impending GDP print.

So have a plan, though a big move isn't necessarily imminent. Possible, but not imminent. Suppose, for example, that next week's FOMC statement takes tapering off the table and is then followed by another near-200K job print. Not exactly the conditions for prices to be fading as we enter August. There are many more permutations, and a garden-variety fade of a couple of percent followed by the traditional late-August rally is as likely as anything. At this point, in earnings season, the modest results haven't been a compelling signal in either direction.

Besides taper-talk, the other wild card is still Europe, a situation that continues to confound not a few. The banking system is still overburdened with debt that can't be written down without using a bail-out system that nobody wants to test. The recent G-20 conference that agreed to talk more about growth rather than austerity isn't going to go anywhere without money, but those who need the help don't have the money and those who have the money don't see the need.

Yet for all that, European stock markets are comfortably higher this year and just got another boost from the electrifying news that the Markit "flash" PMI - which runs higher than the official version - was finally above 50 (neutral) again for the first time in ages. Television impresario Jim Cramer has been suggesting for some time that Europe has turned the corner, and if he is saying that you can be sure that a lot of hedge fund money has been thinking (hoping) the same thing. Barron's headlined its most recent issue with a European recovery piece, though the details amounted to little more than crossed fingers.

A recovery in Europe would be in the history books by now if countries like Greece, Portugal and even France could have allowed their currencies to properly depreciate. The British pound is still about 15% lower than it was ten years ago, while at the other end Germany continues to enjoy the benefit of not having a mark that would be priced far higher than the euro.

One can't help but admire the will of the political elites to keep the monetary union going, but the broad sentimental support that the eurozone has enjoyed has crumbled in the periphery and even France. Most - but not all - of the investment community is willing to accept that the European Central Bank (ECB) has eliminated the tail risk of a eurozone country default or exodus, but that's something of a fiction. What the current strategy really rests upon is the hope that time will heal the crisis before any of the various populi grow restive enough to back a leader willing to exit the currency union.

As I noted above, political choices are extremely difficult to predict. The conventional wisdom is that nothing happens until after the German elections in September. Given that, the calendar, and currently benign market conditions, it doesn't look as if the ECB will want to deviate from that next week.

However, global trade continues to degrade under the weight of the European recession and the slowly imploding Chinese economy, where some old China hands are saying the actual GDP may be half the published rate and perhaps barely positive. I find it a little worrisome that the Chinese themselves currently seem to be bent on socking away land and gold. Are they worried about something?

It's quite difficult to see the rot at the bottom sometimes, yet not every doomsday scenario comes true either. I studied economics in the 1970s, when they were a dime a dozen. Still, I can't get quite comfortable with the current combination of slowing earnings, rising multiples, slowing global economy, record equity highs, central bank printing away all problems. The smartest bond guys I know all admit that the multi-decade bull market is over, yet seem completely convinced that there is still one more top to go. That worries me too.

I ran without hedges for most of June and July, but I've been starting to put them back on. One of the most fashionable investing waves of late has been favoring domestically-focused small caps over big caps exposed to Europe and China. As a result, the Russell 2000 has risen to historically high conditions of being long-term overbought. That's no reason to go out and buy short-dated puts, but you may want to consider constructing some sort of short position on the Russell or its many ETF variants as a hedge.

Disclosure: I am short IWM. 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.