Expected Market Decline Likely to Be Swift and Short

Includes: DIA, QQQ, SPY
by: Finance Banter

While familiarity breeds contempt, investors seem to turn this idiom on its head, as familiarity with the equity markets breeds nothing but love. Judging by the flow of funds into equities (which was noticeably missing during the past two years), and the sentiment readings in very bullish territory, investors want more of this market.

And what is not to love; stocks rise nearly every day and any decline is but an hour or two before some buy program kicks in and pushes stocks to minimal losses. Economically speaking, we are not yet ok, but getting modestly better each week. Unfortunately, much of that “getting better” can be directed to the Fed’s monetary actions – just as Chairman Bernanke confirmed during testimony in front of the banking committee. Although not willing to take credit for the rising inflation concerns around the world (and here too – measured by the rising consumer/producer prices), investors are getting a bit nervous that he will be able to make the necessary changes to monetary policy to avoid an 1970s style inflationary spiral.

While the events of the Middle East have not yet impinged upon the US markets, it is but a matter of time before concerns grow about the supply of oil and civil unrest spreading to additional countries in the area. As those concerns grow, the likelihood of an one-two day “meltdown” grows in the US. Instead of a rolling over of the market and a more “orderly” correction, expectations are rising that the decline is likely to be rather swift and short.

Why? When looking at the history of the markets, especially around event periods like Long-Term Capital and the “flash-crash” last year, the markets were behaving in an orderly fashion in front of those events – more stocks rising than falling and positive volume characteristics that are in evidence today. While overall volume may be very low, the net advancing volume does not show deterioration like in ’00 and ’07 before much longer and deeper market declines. Could the current unrest be cause for a 5%+ correction? Yes, however, unless/until the market internals begin to deteriorate in a fashion that may foreshadow something more significant, we are expecting the market decline to be nothing more than a necessary correction to a strongly rising market.

Yield pressures from concerns over higher interest rates continue to keep the bond market on the defensive and are projecting higher interest rates still in the weeks ahead. The concerns around Libya may push yields lower temporarily as the US may be seen as a safe haven investment environment during troubling times. However, commodity prices continue to rise at well over a 20% annual clip that has persisted for most of the past 18 months. The higher rates are also beginning to have an impact upon housing prices, as purchase activity has once again slowed after showing some promise late last year.

As has been the case for the past two months, the overall picture has remained the same: the “deep cyclical” industries (materials/industrial/energy) and favoring domestic vs. international remain very much the theme of the markets. Like a two-year old telling dad to “do it again”, at some point the equity markets will tire (like dad) and move onto something else. What I’m looking for is that shift in psychology and the favored investments that are likely to shine.

Drilling into some of the industry groups that have been doing well of late and may be beginning their own mini-bull market are auto related stocks. Away from the glaring light of the “new” GM and Ford’s (NYSE:F) huge jump since early ’09 are the suppliers, including tires (Goodyear, GT) and parts (NYSE:TRW). TRW has followed the Ford trajectory higher as it traded for a few weeks under $2 and is now nearly $60. GT also jumped after the market bottom in ’09, however, by fall had peaked and began a yearlong slide of 40% to just under $10. Now approaching $15, the stock is finally beginning to outperform the broader market and may make it back toward the mid-2009 highs of $8, with a target of $22, if $18 can be cleared.

After taking a breather during December and January, commodity prices of nearly all stripes, including precious metals are roaring higher again. I have maintained exposure to metals and energy through the past few months and may add further depending upon developments in the Middle East. I continue to tilt portfolios toward smaller companies (mid/small) as well as in the basic/energy and materials portion of the economy as the “price makers” should benefit more than the “price takers” over the next few months.

Disclosure: I am long F.