The typical pattern now calls for a successful downside retest of the recent lows at best and at worst a breakdown below those lows, extending the decline into a full 10%+ affair. Scarily, over the weekend many publications noted that what was going to happen was indeed a retest of the recent lows and then a resumption of the "bull market." This ebullient sentiment was reflected in CarpenterAnalytix.com's figures, which showed a "jump" in equity exposure last week, from middling levels to new highs. To quote Barron's savvy Michael Santoli, "Lots of technically oriented analysts are invoking the usual pattern of 'retest' of the former lows after this kind of bounce, which raises the pretzel-logic question of whether this is too widely expected to actually happen."
We like the term "pretzel logic," because the markets have a tendency to do whatever it takes to confound the majority of participants. Using that logic infers that the equity markets are unlikely to resume their eight-month bull-run, or that the downside retest of the recent lows will be successful, which is why we remain cautious. Plainly, we have been cautious for months as we have attempted to ascertain if the economy was going to descend into recession, slow to a muddle, or actually re-accelerate. While over that timeframe many of the economic reports continued in their Fox Trot skein (fast/fast followed by slow/slow figures), the slowing statistics of the past few weeks have been concerning.
For example, the Chicago Purchasing Managers' [CPM] report remains below 50 (read: weak), the prices paid component of the CPM report rose sharply (to 63.2 from 54.9), construction spending is down sharply, factory orders are sliding (-5.6%) with non-defense capital goods orders (ex-aircraft) off a shocking 6.6%, productivity growth is slipping (+1.6% vs. +3.0% estimates), unit labor costs are increasing dramatically (+6.6%), consumer sentiment is declining, gasoline prices are rising, nominal retail sales have declined at an alarming rate, and the list goes on. Yet it is not just the recent economic figures that give us cause for pause, but a number of inferential observations as well.
To wit, we didn't like the failure of the NASDAQ 100 (1744.74) and the Securities Broker/Dealer Index [XBD] to confirm February's new highs by most of the major indices. Further, it is troubling that the interest sensitive S&P Homebuilders Index (XHB) and the XBD indexes have collapsed despite the 10-year T-note's recent decline to a yield of 4.48%. Also troubling is the flameout of the sub-prime mortgage market that appears to be spreading not only to Alt-A mortgage loans, but to prime home equity loan portfolios as reflected in Countrywide's (CFC) prime portfolio, whose delinquency rate has doubled. Meanwhile, the costs per unit are rising at the production level without a concurrent increase in prices for the final product. This trend suggests that the long-awaited reduction in corporate profit margins we have often discussed may have finally arrived, with negative implication for capital spending, corporate share repurchases, and many other things.
Still, the thing that worries us the most is our sense that investors' "risk appetite" may be decreasing. We have long argued that while at the margin "liquidity" is certainly a driver of asset classes, the ultimate driver is investors' risk appetite. Verily, if participants have no risk appetite you can push all the liquidity at them you want and they will just take that cash and deposit it in a money market fund. In past missives we have highlighted Merrill Lynch's Financial Stress Index, which does a pretty good job of measuring investors' "risk appetites." We have further noted that emboldened by the straight-up July 2006 to January 2007 "unnatural" rally, investors have embraced ever increasing risk appetites. Recently it feels like that trend has reversed. If that sense is correct, in a mean-reverting world a reversion to the mean in risk appetites implies a fairly stiff headwind for stocks.