As the market crabwalks its way through a difficult period on the calendar, warnings have multiplied about short-term threats to stock prices, ranging from David Tepper to Ralph Acampora to yours truly, who has been warning about post-earnings season vulnerability since mid-March, more specifically since the middle of last month.
The current "which's brew" (as in, "which way are we going?") has three main ingredients, the primary one being that the Fed accommodation needle is moving to a less accommodative stance. The bank is not tightening, to be sure, as its governors would hasten to tell you, but the level of policy accommodation is declining.
That policy shift is supposed to be happening against a subtext of the Fed gently handing off the reins to an economy of self-sustaining private-sector growth. Despite the central bank's undeniably dismal forecast record, the very fact that its monetary policy committee was deeming it safe to move the accommodation needle engendered a widespread feeling at year-end that the economy must therefore be safe by definition (a phenomenon that accompanies every Fed tightening cycle) and a cottage industry of encouraging predictions about accelerating economic growth.
The basis for such predictions was partly psychological - a yearning for better growth rates, a yearning for more money to come into the coffers of asset management, a yearning for more stock rallies - and partly evidential: the annualized GDP rate in the third quarter of 2013 exceeded 4%, the unemployment rate continued to fall, year-on-year rates in home and auto sales looked good. Perhaps the biggest factor was the usual, ever-present herding phenomenon on Wall Street.
The second main ingredient is the economy. As noted above, we are supposed to be experiencing accelerating economic growth (some strategists are already giving up and redrafting this view for 2015), but neither the economic data nor the latest round of earnings reports have supported this view. There is still a little more than seven months to go in the year, but have a look at this chart of retail sales excluding autos and gasoline:
source: US Dept. of Commerce data, Avalon Asset Mgmt Co.
This chart shows the rolling 12-month change in order to focus on longer trends. Some of the weakness in this category can be attributed to the strength in auto sales, where credit is plentiful. Sales growth in autos since the end of 2010, as measured by the Commerce Department's dollar figures, has seen the strongest sustained rates of increase ever in the department's online database, which dates back to 1992. Averaging year-on-year growth rates of around 10%, it's very good for the Chicago PMI numbers, but it also seems to be crowding out of other spending, as it's more than double the rate of nominal income growth.
Doubt has been creeping in about the 3% (REAL) economy, and the above chart is a good reason why. Though employment data has been fairly steady, first-quarter GDP was possibly negative and housing is not going to be the engine of growth this year that was hoped for last year (cf. my recent Housing and GDP essay on the subject). The market stalwarts are insisting that it's all going to happen, some even dropping defiant hints about 5% real GDP this quarter (!) and still claiming that surveys about business capital spending promise deliverance.
The Fed moving the other way, doubts springing up about the economy, add in our third ingredient of the calendar and our brew of anxiety starts bubbling. The stock market is entering a traditionally weak period, and traders know this.
Yet trading is never that easy. The market is indeed set up for a nice correction - probably not the 25% figure I've seen tossed about, a plunge not likely to happen without an external shock - but something in the 10% range, give or take a few, is plausible. But first a catalyst is needed, and until one gets here, other traders are going to try to rerun the short-squeeze of last May.
Some of the reasons for the "sell in May" aphorism are that stocks are usually up in the first quarter of the year (hopes spring eternal with each new calendar year), April is historically the best month of the year, and the first-quarter earnings rally is nearly a mandatory annual rite. Hence, stocks usually emerge from April overbought and overpromised, and some sort of mild correction ensues. Let a market get overextended enough, any whiff of contrary evidence can touch off a partial reversal.
After last year's first-quarter rocket-ship ride for stocks, a correction was universally expected in May - leading to a heavy short position in the market by the end of April. Far from getting a catalyst for a correction, though, markets were instead surprised by the European Central Bank (ECB) announcing an interest-rate cut and all-around policy ease on the 2nd of May. That redoubled the volume on the chorus that central banks are the guardians of the stock market, setting off a ferocious short-squeeze and sending prices parabolic until former Fed chair Ben Bernanke had to remind the markets that bond-buying isn't forever.
This year the S&P has barely done anything, the first-quarter earnings rally was a tepid affair, and a catalyst is still wanting. The ECB didn't act at its May meeting, though it did promise it was ready to act in June, Yellen's Congressional testimony was semi-soothing (it wasn't tightening, so it must be good) and so traders are trying to orchestrate another squeeze - note the push into the FOMC minutes on Wednesday. It wouldn't be much of an upward move, but if a chart breakthrough of 1900 can be engineered, a push to 1925 or so might be pulled off. Not that big of a squeeze, true, but there was no big rally to short.
The problem for bulls is that there is very little else to support such a move upward. Not first-quarter earnings, not second-quarter guidance, not the economy, not central bank policy and certainly not valuations.
Not yet anyway. While everyone is waiting for the correction to come, some events are going to work against it. The jobless claims data indicate no disruption in the employment market (the measurement period ended the week before last), and so I expect that the May jobs report to be released in two weeks time will support the continuation of the taper - and also reignite the narrative of a second-half recovery.
The delayed improvement in the weather suggests that May is the month that will see the rebound in spending, a development so far confirmed by weekly sales data. It'll be just a rebound, but would still run against correction fears and get its share of aggrandizement from investment bank equity strategists. Next week's GDP report isn't likely to favor the strong-economy narrative, but a bad number is rapidly being built into expectations and might slip through without much fuss, so long as it isn't a nasty surprise.
Yet the "new normal" economy is still intact, and valuations are high, so why aren't more people selling in the face of the widely anticipated correction? The larger part of the answer is that most serious money lives in a relative world. Many hedge-fund managers are already running very high levels of cash, but they have been exiting their high-beta positions for some months now. The typical large fund manager has no percentage in selling until something definitive happens - because it might not. If it does, they'll be in the same boat with everyone else. Put options may seem wonderfully cheap, but in a market that is going sideways, they end up being a drag on performance. The angle is not to buy the VIX when it's cheap, but to buy it when it's breaking out to the upside. Not everyone believes in the correction anyway - there are always bulls willing to fall on their swords.
To be sure, any genuinely adverse event will indeed trigger the much-anticipated correction, especially if it contains an element of surprise. But in the absence of such news, the market will do what it always does to the universally-believed trade - something else. Despite the underlying vulnerability to equity valuations, we could be in for some wait before the markets get a proper spooking, one that might only come after the broad market is convinced that it isn't. In the meantime, most investors are just going to sit on their hands and wait. There really isn't much upside to that position, but there is considerable comfort, if not professional safety, to be had from all the company you will have.
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.