There have been many technical-based arguments for an imminent or overdue correction. I cannot add any value there, but instead will focus on some fundamental aspects.
1. Wind behind sails is coming to an end.
I will not argue against the case for recovery here, although I have my strong doubts about its sustainability. But regardless, the earnings season has been a strong wind behind the sails for the month of April. Unfortunately, it's coming to an end.
Lacking strong earnings, economic data alone cannot possibly maintain the same breathtaking pace of the market over the past few months. The persistent pattern of low-volume up days and heavy-volume down days indicates the bulk of money is not convinced of the recovery story or at least its sustainability.
2. Risk of swine flu from Europe is still real and great.
As The Inflation Trader just pointed out, A Greek Tragedy Is Not Priced In. I'd like to point out that, even if we assume Greece can get the bailout money in time to pay for a year, the problem of the rest of PIIGS remains exactly as it has been. What happens when their respective bond maturity waves come in the next weeks and months? The ECB, IMF, EMU, and US for that matter, are one year late for stomping out the fire.
And I'm not precluding the possibility of a relatively effective solution based on my limited knowledge and imagination. My point is, the potential for downside surprises is far greater than the upside.
Europe will no doubt bear the most pain from the European Financial Swine Flu Pandemic. The EUR will drop much further than today's 1%. But risk for contagion to the US and rest of the world, if and when it blows up, is a certainty. Sure, it helps the US by driving up appetite for the USD and treasuries, forcing the world to pretend even longer that the US is the only safe harbor during a storm, and delaying inflation pressure. But it'll just as surely put the viability of the global financial system into question again, kill the fragile if real recovery and threatens the prolonged, worldwide deflationary spiral. China's overheated risk will solve itself instantaneously. But in the same breath they'll face the much tougher question of how to survive another round of worldwide demand destruction.
By the way, if they had dissolved the EUR and let the PIIGS default and devalue their own currencies as they may, the contagion would be much less severe. The defaulting PIIGS may suffer from the same pain if they implement the necessary austerity measures, but at least the pain would be their own choosing. But that's another topic.
3. Financial reform will happen and it's negative for banks.
Personally I'm a strong supporter of the Volcker Rule. But if just this part of financial reform is implemented, and even though it's better for everybody in the long term by reducing systemic conflict of interest and risk, short-term it's a definite negative for financials. The earnings power of One-Stop Financial Shops will be greatly diminished. Even the spun-out prop trading entities will lose substantial value because they will lose much of their prior unfair access to financing and information, as well as much of the leverage of infrastructure. Goldman (GS) might as well go private and that'd be a good thing for the firm and the system.
I don't know when the Volcker Rule will become a reality. But the downside risk will be recognized more and more by the market.
If Goldman settles with the SEC or the criminal investigation turns up nothing, then it'd be a boost for Goldman. But I doubt the short-term boost would spread to the sector. First of all, what's happened since the SEC charge has already made it much more difficult for the SEC to settle. Secondly, even if the SEC settles with Goldman, it's a political necessity for them to expand the probe to other banks; and if they don't settle, then of course they must pursue other banks too. Furthermore, great earnings from banks have become their liability in this climate. If I were a bank, I'd forego a big part of my profit and make risky loans for a few quarters. It's irrational, but rational on another level.
4. BP oil spill still has great downside potential.
Wait until the spill reaches shore. And the hurricane season is fast approaching. If they can't stop the spill before a hurricane hits, are we looking at a 6-month spill and oil rain over a large part of the southeastern US? Will the dark-colored spillage accelerate a hurricane formation?
Regardless, certainty includes countless lawsuits for BP and a higher cost for all deep-sea oil drillers, as well as huge economic and environmental damage to the gulf coast region.
I don't know when the correction will come. But the probability of one, in the order of magnitude of 10% in the next few days to weeks, appears very high.
Disclosure: Short FAS
