Market Top or Minor Pullback?

Includes: DIA, QQQ, SPY
by: Cam Hui, CFA

Despite many of the macro risks that face the market, my models and indicators are telling me that the current bout of weakness is just a minor pullback to be bought, rather than a more serious intermediate term top, which I expect to develop later in the year. My conclusion is based upon the following:

  • Model: The Inflation-Deflation Timer Model, which is a trend following model as applied to commodity prices on the basis that commodities represent the "canaries in the coal mine" of global growth and inflationary expectations, remain bullish on the "inflation" or "risk" trade.
  • Technical: Secondary indicators of risk aversion are still trending towards the "risk-on" trade.
  • Industry fundamentals: Current market weakness is based largely on fears of the effects of a cutoff in Libyan oil output and how such a price shock might impact the fragile global economy. Analysis shows that the expected effect of any disruption is likely to be minor. The markets appear to be starting to discount the worst case scenario a contagion effect of the popular unrest spreading to Saudi Arabia.
  • Sentiment: A surprising quick retreat in bullish sentiment in the AAII surveys after this week's market weakness is contrarian bullish.
For the time being, my base case is that the current market action represents a minor correction. Should the weakness continue and violate the uptrends evident in the indicators, then my risk control discipline would then turn more defensive.

Inflation-Deflation Timer Model
The Inflation-Deflation Timer Model looks for a price trend in commodity prices, largely because commodities are considered to be a highly sensitive real-time barometer of global growth and inflationary expectations. A look at the CRB Index shows that commodities remain in an uptrend.

Given the recent geopolitical turmoil in the markets, it would be expected that headline commodities such as oil and gold would be in rally mode. But the Timer Model considers all commodities, not just precious metals and energy. Last week, before the Libyan unrest news hit the tape, it was the turn of softs and agricultural commodities to rally (remember all the news about food inflation in the emerging markets)? In fact, softs such as cotton have taken it on the chin this week.

Net-net, the entire commodity complex remains in a healthy uptrend. In particular, the price of Dr. Copper is staying in an uptrend.

Risk aversion measures still trending to "risk"
As well, the intermediate term trends in the risk aversion measures remain in "risk" mode. Consider, for instance, the ratio of Consumer Discretionary to Consumer Staple stocks as an indicator of the cyclical, or reflation trade:

We see a similar pattern in the relative chart of the Morgan Stanley Cyclical Index compared to the market:

Some of these indicators, such as the copper price and the Consumer Discretionary to Staple ratio, are testing their uptrend lines. Until we see violations of these trendlines, my inclination is the give the bulls the benefit of the doubt for now.

Oil shock analysis
James Hamilton has written extensively on the effects of oil shocks on the US economy. His latest analysis indicates that any effects of any Libyan supply disruption are likely to be minor [emphasis added]:

Libya recently accounted for a little over 2% of global oil production. If this is entirely knocked out, it would represent a shock that is only 1/3 the size of the smallest of the first 5 historical disruptions summarized above, and perhaps comparable to Venezuela-Iraq in 2002-2003...

The particular dynamic model from which the above Brookings figure came builds in quite strong nonlinearities and threshold effects. Interestingly, according to that specification, one wouldn't begin to anticipate significant effects on U.S. GDP until the price of oil got above about $130 a barrel, or until the second half of this year. Prior to that, according to that specification, we're still ok.

I don't want to make too strong a claim about those particular details. It's very hard to claim precise statistical evidence in support of one choice of a threshold over another. But, this particular model has held up fairly well since its original publication in 2003. So I'm not about to abandon it just yet.

My bottom line is that events as they have unfolded so far are not in the same ballpark as the major historical oil supply disruptions, and are unlikely to produce big enough economic multipliers that they could precipitate a new economic downturn. They might shave a half percent off annual GDP growth, but I don't anticipate a whole lot worse than that.

The current level of market panic appears to be related to the risk that the Tunisian/Egyptian/Libyan unrest contagion could spread to Saudi Arabia. Already, the House of Saud has responded with a giveaway:

Saudi Arabia's King Abdullah returned to the kingdom Wednesday after a three-month absence for medical treatment and introduced a number of nonpolitical reforms amid regional uprisings that have toppled regimes in Tunisia and Egypt and infected neighboring Bahrain.

The social and economic overhaul, estimated to cost around 135 billion Saudi riyals ($36 billion), include housing support, funding to offset inflation and guarantee of payment for students overseas, according to a series of royal decrees published on the official Saudi Press Agency, or SPA. They come as political upheaval continues to sweep the Arab world.

We can get an idea of the level of tension in the markets by monitoring Intrade for an assessment of the stability of the government of Saudi Arabia's neighbors. Currently, the odds that Prime Minister Khalifa Bin Salman Al Khalifa is no longer the Prime Minister of Bahrain by December 31, 2011 is about 60%. To the south, the odds that Ali Abdullah Saleh is no longer the President of Yemen by December 31, 2011 is about 65%.

The markets appear to be focusing on the nightmare scenario based on the threat of political turmoil to Saudi Arabia's neighbors. When markets start to discount the worst, it is time to buy. However, given the level of these Intrade odds, the risk premium may continue to rise and there may be further downside to this correction.

Is the retail investor capitulating already?
The final bullish underpinnings to this market is the recent reading out AAII showing that bullish sentiment fell from 46.6% to 36.6% in a single week. Given that the survey was done on Tuesday and there has been further weakness since then, it is likely that bullish sentiment has deteriorated further. Such levels of panic in the face of minor weakness is generally viewed as contrarian bullish.