A Different Outlook For 2014 - Part 2

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

In Part One of this series, I made out the odds for a significant stock market correction (greater than 10%) to be about 20% for the first two months of the year, 50% in the spring, and 30% in the fall. This week I want to discuss some of the reasons for those odds and ways to position for the different scenarios, before concluding with an abbreviated snapshot of the market.

Corrections do not often happen in January. The tendency for an up month is so pronounced that when the month actually is down, it isn't a good sign for stocks that year, according to the Stock Trader's Almanac: "Every down January on the S&P since 1950, without exception (italics theirs), preceded a new or extended bear market, a flat market, or a 10% correction." That's actually a wider range of alternatives than it may seem. Sometimes January is down in the midst of a bear market - 1982 and 2009 come to mind - so that even though the market did indeed fall by more than 10%, a new bull market has soon followed (quite a good one in those two cases).

We are most certainly not now in the midst of a bear market, whatever else one can say; whether or not one is ripe to begin will only be clear in retrospect. One cause for concern is the First-Five-Days indicator being negative: a positive year follows when the first five trading days of the new year are net positive on the S&P 500 about 88% of the time, and the first five days of this year on the S&P were down, despite what appeared to be a frantic attempt to rally the tape in Wednesday's closing minutes. Before you reach for the cyanide, however, the converse is not necessarily true, as a negative first five days produces a down year only about half the time. Still, a 50-50 shot is something to think about.

Sentiment in the beginning of the year is typically constructive. Corporate management predicts great things (in recent years, the great things have been located deep in the mists of the second half), Wall Street analysts issue rosy estimates and tell us why every valuation is justifiable, mutual fund managers go on television to assure us it's a great time to be buying stocks - stop worrying about the price, says Jeremy Siegel, returns have always turned out to be positive. Within twenty-five years. Except for that one time.

In recent years, each January has also been greeted with the declaration that this is the year the economy reaches escape velocity. Add in the known trading elements that the November-January time frame is historically the best three months of the year, that November-April is the best six months of the year, and that every trader knows this, and you know why things have to get rather overripe in Denmark for those rules to get broken.

By comparison, springtime corrections are common, usually occurring sometime between the end of earnings season in late April and the middle of June. The "best six months" period draws to a close ("sell in May and go away"); often less money is being put to work; the first estimate cuts have rolled in; or perhaps the market is simply overbought. In those years when we are headed for a negative year, four or five months in is often the time when optimists tire of rearguard action and doubts about the invincibility of the market take hold.

An excellent case for a springtime correction in 2014 can be predicated on the idea that the Fed might be halfway through its wind-down of quantitative easing by then. If the 2014 economy is doing exactly the same as the 2013 edition - quite possible - and the unemployment rate were to have worked its way down to 6.7% by June, for example, it would leave the Fed with little choice but to keep up the exit, regardless of whether the decline rested on how many people were dropping out of the labor force, or toiling away with advanced degrees at restaurants and bars. All of the FOMC members but James Bullard are old enough to remember the 1970s, and no one wants that era to return. I cannot remember a market that didn't ignore the first signs of tightening, nor one that didn't eventually succumb to it.

I'll repeat last week's observation, however wrong it may feel to the less experienced: current equity and bond prices cannot withstand much in the way of a growth increase. A little bit of growth is alright, but more 1.5% real growth would be even better for stocks, strange though it may sound. If jobs growth were to ease to a rate of 190K a month, and then 180K, that would keep both QE and the chimera of profit growth next year ("forward valuations are reasonable") on the table.

The last scenario could lead to stocks putting on another 20% by the fall, especially if the European Central Bank (ECB) were to join the party with another rate cut. If traders can be convinced that we live in a land without fear of inflation, profit decline, or monetary tightening, there is no telling what they might get up to. Valuations won't matter and neither will profit growth, so long as it is minimally positive. 2013 was the demonstration proof of that. Trees can't grow to the sky, but momentum traders would love to have another helping of irrational exuberance.

In the low-growth, minimal-to-no taper scenario, nifty-fifty type stocks would do well, so long as they can grow the top line. Earnings won't be any more relevant to the stock prices than they've been for the last couple of years. That said, the latest Fed minutes infer a committee that really doesn't want to get to $5 trillion on the balance sheet. I don't see it happening.

In the mild-growth, some-tapering scenario, at some point the market corrects, and it should be signaled by continue upward pressure on bond yields. This is the environment a plurality appear to believe in (or perhaps just plain fear) right now. Utilities and telecoms should be the first to fare badly on this path. While there are high-yielding telecoms out there with solid valuation cases and juicy yields, they would get cut down just the same. It's just the way the business goes.

In the faster-than-expected growth case, markets will bounce around a while with some decent-looking days and weeks before tumbling. I realize that some strategists are trying to have their cake and eat it too these days, saying that a bit more extra growth makes valuations reasonable, while a bit less keeps the Fed spigot on. What I would say is that while many forget it and some haven't yet learned it, markets can start to correct while economic growth is accelerating, just as they can start to rally before a recession has bottomed out.

For those with low attention levels to the market, I've been recommending doubling your cash exposure as of the end of 2013, and then keep reducing equities by another ten percent for every quarter that is still up without correction. For those who can't bear to have much cash around until it's too late, a fund that I like these days is the Pimco Long/Short Equity Fund, available in different classes as PMHIX, PMHPX, PMHDX, PMHAX, PMHCX. It will do better than the S&P in a decline, and still give you some upside in the blow-off top scenario.

With bonds, I would heed the advice of Mohammed El-Erian (an interview worth enduring the irritating ad): stick to the short end of the curve. He also signaled a sentiment that has gained a lot of institutional currency in recent months - an allocation shift away from US equity towards less-performing regions, in particular Europe (I wrote about this last week as well). Regardless of the merits, that sentiment could translate into downward pressure on US prices and upward pressure on European issue prices (NYSEARCA:VGK).

Finally, the jobs report on Friday rates to tell us more about the markets than the real economy. If prices sell off on a number that matches or beats the ADP estimate of 238,000 (keep in mind that ADP want its model to anticipate the Labor Department data, not actually improve on it), the First-Five-Day negative indication is likely to be a true omen. Conversely, should they rally on a good-sized, yet not too shocking shortfall, the blow-off top scenario definitely gains more consideration.

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.

Additional disclosure: I am long PMHDX.