The Early Case For A First Quarter Top

by: Kevin Flynn, CFA

While the lack of movement in the S&P 500 during this earnings season is something of a warning - hanging out just below its year-end close, when on a "seasonally adjusted" basis it should be up one or two percent - I don't yet see it as a harbinger of imminent danger.

I do see it as a sign that the market has lost some of its high-octane fuel, but not run out of it yet: The higher-beta Russell small cap index (ETF: IWM) and the Nasdaq index (ETF: QQQ) are both up over a percent, as is the S&P mid-cap index (NYSEARCA:MDY) (there are other ETFs for these indices, but the ones I listed are the most liquid). Clearly some traders are anticipating a resumption of business as usual, perhaps an imminent upside breakout on the S&P. All three of these ETFs noted made new 52-week highs on Wednesday, all are overbought on the intermediate and long term, and the IWM is rapidly heading for short-term correction territory (or if you prefer, a chance to buy the dip).

If you're wondering what might drive the S&P higher, the answer could come next week, when earnings reports began to tilt towards big-cap tech names. Apple (NASDAQ:AAPL) and Google (NASDAQ:GOOG), two of the top three stocks in the S&P, are reporting next week, along with number-two market cap Exxon Mobil (NYSE:XOM) and high-flier Amazon (NASDAQ:AMZN). Microsoft (NASDAQ:MSFT) reports today (Thursday) after the close. It isn't just the market-cap weighting of these stocks that matter, but their higher profile and better-than-average revenue growth as well, at least for Amazon and Google. The former is a cult stock whose lack of earnings don't matter - it has only to report results for the stock to go up, and traders are probably anticipating more of the same.

In the midst of those reports will come the FOMC (monetary policy) statement on Wednesday. I wish I could tell you how to position for the meeting, but I can't do any better than suggest following the current cycle's rule of thumb that equities rise into the meeting and sell off afterwards. Sometimes the fade begins the next day, sometimes that afternoon, depending on how high hopes have been raised. In the current case, the bar would appear to be low, especially after Fed confidant and Wall Street Journal reporter Jon Hilsenrath penned an article this week reporting the Fed was on its way to continuing the taper down to a still-substantial $65 billion per month.

With the market thus duly warned, experience suggests that an announcement to that effect could not be a negative surprise, obviously, but even the occasion for another rally. That may seem counter-intuitive, but momentum is momentum and bull markets typically rally through the initial stages of the Fed withdrawing accommodation. The phenomenon is a mix of things - bull market bravado, the reassuring shibboleth that the Fed is on the job, relief it didn't do something worse than feared, applause from equity strategists that growth must be getting better and hence profits (or the Fed couldn't possibly behave in such a manner). Throw in short squeezes and the pain trade and you find that a rally occurs more often than not, regardless of the fact that the distance to the cliff-edge may be rapidly diminishing.

In fact, the FOMC meeting may have more room for upside surprise rather than downside. Forecasting policy decisions is another form of roulette, in my opinion, but that said, we don't yet know if Yellen is going to live up to her very dovish reputation. It's often the hard-liners that most surprise you - think of Nixon going to China - another reason not to be too sure of anything, but prevailing sentiment is that she has been even more pro-QE than Bernanke. With no press conference on tap, she may only have to forgo any sudden changes for the markets to put on a relief rally.

The sudden and unexpected resignation of Pimco's Mohammed El-Erian has led to speculation that he is in line for an impending Fed nomination (one seat remains to be filled), a rumor that gained currency in light of his ties with vice chairman-nominee Stanley Fischer. Lord knows the FOMC could use someone with market experience, though whether they heed any of it is another question. Bernanke relied on the supposed market acumen of former Treasury Secretary Hank Paulsen, who rather astutely predicted that markets would rally upon learning of the Lehman Brothers bankruptcy (it's only fair to El-Erian to add that his problem of usually being the smartest person in the room would be the exact opposite of Paulsen's). The committee's make-up is changing, shifting its tilt as well, but I believe markets would welcome an El-Erian nomination.

If the FOMC does come out with Hilsenrath's expected policy and a purchase reduction to the $65 billion level, along with the usual assurances that short-term rates will remain at zero as far as the eye can see, then a rally could gain additional fuel from the tech stocks cited above, bringing fresh boasts in the media about stocks being at all-time highs and the invincibility of the market. Another wave of retail late-comers might be incented to regret their missed dip opportunity and take the plunge.

Though I recently wrote that we should get a significant market correction this year, I still believe that it isn't likely in the early going, barring some geopolitical surprise (the chances of which appear to be slowly growing). Judging by the behavior of the more speculative indices and very high levels of bullishness, I rather think it more likely that we have another move higher first, one that would appear to nullify the slow start to this year and fuel higher volumes of cheering. It's just the way these things go - bull markets usually end in blaring trumpets of victory, not bold black headlines of disaster (the latter usually come long after the bear has started walking).

Despite the headlines about the Bloomberg survey reporting five-year high levels of bullishness, there has nevertheless been quite a bit of public fretting about equity valuations (I've been worrying about them myself for months), now that the calendar has turned and the Fed can no longer be counted on for infinite joy-juice. The latest Barron's roundtable found itself split in half. That sort of anxiety gives the market something to rally against, as momentum and surprises are what moves prices the most in the short term. After the lead balloon of the December jobs report, the January report due in two weeks time has the potential to be explosive.

The combination of a very late Thanksgiving and unseasonably cold weather played havoc last month with the weekly claims factor, something that most pundits seem to have missed (especially the economic mavens on the two most prominent television news channels - not to name any names). Claims generally ran about 10% lower in 2013 than 2012, but that was not the case when comparing the two-week jobs-reporting periods of December 2012 and 2013 (the Bureau of Labor Statistics (BLS) uses the week of the month that includes the 12th day as the cut-off). Unadjusted claims were actually more than 5% higher in the BLS-defined first half of December 2013, quite unusual behavior for the year. The raw data was partly masked by the seasonal adjustment factors that are calculated in advance and in the event were something of a guess, given the unusual confluence of holiday and weather. In the January 2014 period, however, the trend resumed: Unadjusted claims were down 8.6% versus the first two weeks of January 2013.

The February report also comes with benchmark revisions that are widely anticipated to add more jobs to the tally. I'm not so sure about that this year, as there is currently a huge divergence between 2013's tally of gains in the household survey (1.46mm) and the establishment count (2.192mm). It should be noted that the former does not double-count the employed, while the latter does (if you're working three part-time jobs, for example, the establishment survey counts you three times, the household once). The BLS also seemed to make an extra effort during the year not to undercount, but we will see in two week's time. The point is that another 200K-type result, coupled with a decent upward revision to December, could reignite a US growth narrative that most of the investment world seems to have bought into - in other words, confirmation bias - and make the stock market forget about the taper, at least temporarily.

The sequel to such an event is that it would leave equities vulnerable to downside disappointment if the first quarter doesn't deliver on growth. After all, employment is a lagging indicator, and last week's JOLTS (labor turnover survey) report on November was hardly dynamic anyway - when the retail sector is taken out, private sector hires were actually down compared to November 2012.

Yet the BLS gave favorable treatment to layoffs in the retail sector this time last year, so any similar bloodletting this year in the sector - and judging by all of the recent markdown and margin warnings, it could be substantial - could conceivably be masked in the early returns. Though I try not to guess the monthly BLS headline result, the early signs do point to a reversal of December's disappointment and thus a path to a first-quarter top in equities. That kind of blow-off would tilt the eventual correction potential from 10%-plus to 20%-plus, but I wouldn't expect to hear much about that danger right away - it'd be drowned out by the din of all the chest-beating.

That brings me back full-circle to Amazon and Google. Google is expected to post $60 billion in revenue for all of 2013, yet has added $100 billion in market cap in the last three months alone, while Amazon has added $45 billion in market cap over the same period, to go with its $75 billion in expected 2013 sales. It wasn't as if either were oversold - both are up over 50% in the last 12 months. That kind of concerted rush into "nifty-fifty"-style stocks five years into a bull market is the kind of froth one finds in the stages of a blow-off top, not the early going of some two-year fresh extension to the bull that the Street is trying to sell us. I wouldn't short these issues going into earnings, but if the momentum keeps up much longer, I'd use the opportunity to start easing out of such positions by quarter-end - and not only those.

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.