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The recent Employment and Housing data have not provided confirmation for the surge in bullish sentiment observed in December (unless you read the extreme sentiment as a contrarian indicator). The market exhibited a delayed reaction to another well-known technical indicator this summer, and I believe that’s happening again in this case.

I first made note of the market’s unusual exuberance in July (Stock Indexes Ignore Technicians’ Head and Shoulders Calls). I found it odd that the market was enjoying a rally, despite the fact that stock prices had just completed a classic head and shoulders pattern. Of course, the predicted correction arrived in the fall, with a delay. Here’s one case in which the head and shoulders signal was profitable — there was plenty of time to make adjustments to portfolios or hedge the expected decline in equities.

I believe the case can be made that the same type of delayed reaction to the extremely bullish sentiment from December (a classic market top signal) is developing now. Just a few weeks after the surge in positive sentiment, we received unequivocally bad reports on variables that will be key in 2011-2012: housing and employment. The recent dip in the Case-Shiller Index:

Click images to enlarge

and weak additions to Total Non-Farm Payrolls:

simply confirmed that analysts and pundits are, once again, too bullish. Moreover, when you also consider the trend in the Core CPI:

the recent numbers are more consistent with the Fed’s deflation scenario.

Why should the market exhibit a delayed reaction again, this time to the extreme optimistic sentiment from December? Asset prices reflect a premium for the Bernanke and other de facto put options that remain in-the-money, at least for now. These mechanisms encourage excessive risk-taking, which results in expected returns getting bid gradually lower. Just look at commodities prices. The market is running on animal spirits. Investors and traders are out of the habit of even looking at data — the market’s been shrugging off bad news for almost 2 years now (see Cullen Roche’s classic post from December 27, Equity Valuations are Stretched — But Does it Matter?). Combined with Goldman Sach’s trotting out Abby Joseph Cohen to shout “Synchronized Global Boom” in crowded theaters, the market’s had every possible signal of a short-term top thrown in its face — and valuations will most likely correct sometime in the next month or two, exhibiting the same delayed reaction as we saw following the July head and shoulders pattern.

Regarding the Fed’s ongoing involvement in markets, businesspeople and bankers who are in the trenches continue to acknowledge that these government mechanisms have been, and unfortunately continue to be, necessary to obtain the level of financial stability and confidence necessary for economic growth. And there’s no shortage of regional and community bankers who are still plenty nervous.

It’s a little scary to think that much of what we’ve accomplished thus far amounts to merely substituting 1.) government guarantees, 2.) a massive transfer of bad paper from private to public balance sheets, and 3.) ongoing zero real interest rates for the leverage infused into the financial system in the previous decade. The various guarantees and Quantitative Easing programs are merely leverage substitutes, only some fictitious future US taxpayer is on the hook for the whole thing. The US economy and financial system are not ready to take off the training wheels.

Put another way, the multi-decade experiment of coming off the gold standard has led to a grotesque endgame: The Federal Reserve desperately propping up asset prices and throwing everything it’s got at the problem of creating inflation (a task at which it has been completely unsuccessful thus far). I find it more than a bit macabre that we’ve all casually accepted that the best thing for long-term national prosperity is to debase our currency as quickly and completely as possible. Someone tell me again how that makes sense — I keep forgetting.

Yet another thing I regret having to write, but needs to be written nonetheless: The recent data suggest that we might not want to pull back on all those Federal Reserve pro-liquidity programs just yet. It’s not so much that I’m motivated to give the Fed credit for getting anything right, I just think in this case we have more of an accidental matching of the right medicine and the right time. I’d like to see the economic data firm up a bit more, preferably in a recognizable trend, before the Fed changes course.

Source: Latest Housing, Employment Numbers Suggest Q1 Correction