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In our market update last week, which can be found here, we discussed our observation that the market is not rallying through the current earnings season like it did in February when Q4 earnings were released. After a strong rally, it seems that the market is settling into a trading range between 1,350 and 1,425 on the S&P 500 (NYSEARCA:SPY). Following the declines at the end of the week, it looks like the market may test the bottom of this range. If a breakdown from this range emerges, the market could see sharper declines in the near term.

(click to enlarge)

Risks To Worry About This Summer

We are focused on four risks to the market over the next few months:

  • Economic activity and corporate earnings
  • The Fed and the end of Operation Twist
  • Fiscal Cliff
  • Europe

A few months ago, market participants seemed to be a lot more bullish on the economy. Job growth seemed strong and Q4 corporate earnings, released in January and February, fueled a rally.

Since then the pace of job growth has slowed. According to the April jobs report, released on Friday, 115,000 new jobs were added to the economy, falling below expectations.

The market may have over-reacted as these numbers still showed job growth, not job losses and the jobs number tends to be revised. The March number was revised up to show a gain of 154,000 jobs instead of a gain of 120,000 jobs as initially reported. We want to wait a little longer to see the real trend and not focus on a couple of data points. However, the market's reaction is as important as the actual number and the reaction was clearly negative.

Despite the weakness, things aren't bad enough to warrant more action from the Federal Reserve. With the Fed's Operation Twist scheduled to expire at the end of next month, the market may be losing an important crutch that has supported it for the last few years. The Fed says it is not going to raise interest rates until 2014, but it seems that it is not going to launch QE3 (another round of quantitative easing to help bring down interest rates and boost the economy) as some are hoping for. The Fed's stance could be viewed as another negative for the market.

The U.S. elections will grab a lot of attention through November. The divisive nature of the national debate may not be good for the general mood. More worrisome is the upcoming "Fiscal Cliff." At year end, the Bush era tax cuts are set to expire, unless Congress acts to extend them. If the Bush era tax cuts are not extended many will face higher taxes and, importantly for investors, the capital gains and dividend tax rates will go up. Higher taxes could negatively impact economic activity and investors may want higher rates of return to compensate for the higher taxes on their gains and income. With these fears, the Fiscal Cliff could be a catalyst for market declines.

Finally, Europe could continue to export bad news to the rest of the world. With French and Greek elections on Sunday, new leadership in Europe could lead to more uncertainty. Spanish and Italian 10-year bond yields are still near 6% (though slightly below recent highs), so the market is expressing a lot of concern about the situation in these countries and Europe, more broadly.

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(Source: Bloomberg)

(click to enlarge)

(Source: Bloomberg)

Old Leadership

It is interesting to watch the decline of some of the recent market leaders. As these leaders experience small corrections, the market will need to find new leadership to push it higher.

Apple (NASDAQ:AAPL), for example, has now lost most of the gains it achieved following Q1 earnings and is back below its 50-day moving average.

(click to enlarge)

Other stocks that rallied in Q1, but have faced weakness recently include: Starbucks (NASDAQ:SBUX), Chipotle (NYSE:CMG) and Qualcomm (NASDAQ:QCOM).

Oil prices also showed weakness as WTI closed below $100 for the first time since February. Low oil prices are good for the economy, but the fact that oil prices are low may indicate that demand for oil and economic activity are weak.

There could be many reasons for the decline in oil prices and we want to wait before drawing conclusions. The decline may have been caused by actual or perceived weak demand or it may have been caused by high oil inventories reported earlier in the week. Also, at the beginning of the year there were worries about Iran's nuclear program and the potential response to it. At the time, it seemed that these worries were contributing to the rise in oil prices. With less talk about this recently, the "Iran premium" may have come out of the price of oil.

(click to enlarge)

(Source: Bloomberg)

Whatever the reason, energy stocks may have trouble rallying if oil prices continue to decline, especially with low natural gas prices.

The market may not be able to look at the small/mid cap space for leadership, if big tech, as personified by Apple, and big energy face weakness. The Russell 2000 has been flat, or rangebound, since February and still has not reached the highs of last summer.

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With some pockets of the market moving from leadership to weakness, it may be difficult for the market to pull out of the range that we discussed earlier.

Silver Lining

Despite the risks and the recent weakness, we are not entirely negative. Many of the risks mentioned above are apparent to market participants and may already be factored into stock prices. Furthermore, the economy is continuing to expand, even if the pace is slower than projected and hoped for. Q1 earnings have been good overall, even if expectations were lowered going into earnings season. Corporate balance sheets continue to be strong as many companies have cash that can be used for acquisitions of investments. With low interest rates companies with high debt levels are benefiting from lower interest expenses while they pay down debt and work through problems they may have.

Investment Plan

Investors can always point to some good news as a reason for the market to rally or bad news as a reason for the market to fall. With the market seemingly in a trading range both sides are balancing each other out. We want to be mindful of the reasons supporting the bulls and the bears so we can react quickly if conditions change.

Until the market emerges from its trading range in either direction we are planning to increase our cash position. We are selling some stocks and reducing our exposure to focus on our highest conviction ideas. Also, some of our portfolios have short positions and we will look for additional opportunities on the short side.

At our core, we are fundamental investors. However, we recognize that the overall market trend can be used in our favor or against us and we want to remain nimble so that we can use market trends to our advantage.

Disclosure: We have a position in the ProShares Short S&P 500 ETF (NYSEARCA:SH). We may trade this position or the stocks mentioned in the article in the next 72 hours.

Source: Market Update: The New Trading Range And How To React