Market Update - The Correction Has Begun

 |  Includes: DIA, QQQ, SPY
by: Jeremy Robson

I wrote an article here suggesting that the S&P500 (NYSEARCA:SPY) would stall at its 2011 high and then retrace to one of its support points (also suggesting that the most likely support will be around the 1250-60 area). It looks as though the first part of that call is happening now. The market has broken its 10- and 20-day moving averages to the downside, which would indicate that the correction that everyone and his dog has been calling for, has finally begun. As long as the daily close for the 6/3/112 is below the 20-day moving average, this will be confirmed.
Since my article of the February 14, 2012 the support points have changed slightly and I would like to update them. They are now

  1. 1320
  2. 1300
  3. 1289
  4. 1268

In the previous article I suggested that this correction would lead to another rally that would likely take the S&P500 to new highs. I am now undecided on this rally. Both the Dow and the Nasdaq show a pattern that suggests that we may have seen an intermediate-term top (intermediate being the next 6 months) but the S&P500 does not. However I still feel that the most likely retracement for this market correction is around the 1268 mark. It is what happens after the correction that I am undecided on. To try and decide what comes after the correction I will be monitoring the following:

1. The economic data out of the U.S. I still believe that the U.S. economy is weak, with present growth around the 1.5-2%. If this is true the jobs growth will slow as the year progresses and the economic data will peak in the next 2 months. If this is not the case then I will be wrong and the economy will be on a higher growth path. If I am right the U.S. economy is vulnerable to external pressures from the rest of the world.

2. Europe is going into recession. I have not in regard to any market calls been relying on a financial crisis. The plan in Europe revolves around serious austerity that will likely mean the recession in Europe is more pronounced than is currently priced into the market. I hold to this call unless Europe changes its policy on austerity. There have been calls from the Spanish government for some expansionary policies and Spain has just suggested that its fiscal deficit will be 5.8% of GDP in 2012. They have not suggested that they are going to make any changes to the budget and will therefore miss their budgetary targets. Francois Hollande, the Presidential candidate in France has suggested that, if he is victorious, he will renegotiate the fiscal pact for a more expansionary policy. The Netherlands have just admitted that it will not hit a budget deficit of 3% of GDP in 2013 but has not suggested any changes to the budget. If austerity is abandoned and quietly pushed under the carpet, budget deficits across Europe will rise. We then face the difficulty of how to finance these expansionary policies. Will the Germans relent on their hard line stance and just allow the fiscal pact to disintegrate? More importantly, the only way of financing the expansionary policies will be for the ECB to monetize the debt as it seems extremely unlikely that private capital will subsidize more spending. Will the ECB print for European governments' spending, if austerity is proven a sham?
It would seem that the most likely course is still austerity. However if austerity is abandoned and the ECB monetizes the debt the market will shoot higher. In the current economic malaise it would not entirely surprise me if austerity was quietly abandoned. It is not my base case however.

3. Japan has suggested that it is targeting 1% inflation. This seems a very dangerous proposition for a country that has a debt-to-GDP ratio of 235%. If it succeeds the rates that it is paying on its debt will surely rise. The weakening of its currency lately is worrying. I would suggest that this is the most concerning world development since my article of February 14. Could Japan be about to unravel due to a policy that it instituted itself?
You may suggest many more black swan events, which may plague the markets, but these are completely unpredictable and currently the market seems to be ignoring all of them and will only reflect them in the price, if they occur. This is most likely because of the dearth of assets that are producing a return on capital. Many market participants are being forced into equities with their eyes firmly shut to the risks, so that they can pick up a return. It would seem likely therefore, that the market will continue to discount only the events that there is clarity on, despite the risks that are hidden. If any of these black swan events play out they will have a negative effect on the market; if they don't they will continue to be ignored. As the position becomes clearer in Europe, Japan and on the U.S. economy (all of which ought to be reasonably visible) in the next couple of months the market will move in the direction that best reflects the outcomes. It is currently unclear what those outcomes will be.

This may result in another rally or a continued fall. For all of you who have been brainwashed into the view that this is a correction to be followed by a rally to new highs, I would suggest that you keep an open mind and watch to see what the U.S. data show and how the policies in Europe and Japan work out during this correction, before you place your bets.

As stated in my previous post, market predictions from anyone (including me) in the short term should be viewed with a healthy dose of skepticism.

Additional disclosure:

Long RWM, short S&P500 futures

Disclaimer - This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.