Market Pessimism Is Overdone

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Includes: DIA, QQQ, SPY
by: The Simple Accountant

Financial markets were in a somber mood last week, as they digested uninspiring economic data, and the troubling Greek and French election results. There was a distinct note of risk aversion, but more along the lines of an orderly retreat than indiscriminate selling. Where does this leave us as we look to the second half of May? Let's dig into the details to see if we can find a little clarity:

Perspective

Stocks: The "sell in May" mindset continued to dominate equity markets last week, sending all of the major U.S. equity indexes further into the loss column. The worst of the selling came early in the week, and the market appeared to be firming Thursday. Friday's trading, however, made it difficult to remain optimistic in the short term, as a morning rally gave way to selling pressure that came in before noon, and drove share prices down steadily through the afternoon session. Sector action was very defensive, as utilities put up the only real positive move among the nine major S&P 500 sectors, while health care and consumer staples were flat to slightly off. The rest of the sectors saw losses in the 1.5 to 2% range.

Eleven of the twelve foreign equity indexes we monitor posted losses, the lone holdout being Germany's DAX Composite, which managed a small gain amid deepening European uncertainty. Some of the worst losses came from Japan, where the Nikkei has given back all of the February - March rally.

Bonds: The risk aversion that has been so tough on stocks has been good for the bond market, as investors seek safety in uncertain times. U.S. Treasury yields fell for the eighth consecutive week, and the long bond briefly traded under 3% Wednesday. Corporate bond yields, already at generational lows, also fell across the board. Interestingly, the general risk aversion did not extend to junk paper; the BofA Merrill Lynch US High Yield Master II effective yield closed the week just above 7%, near an all-time low. Inflation protected and municipal bonds also fared well.

Commodities: Commodity prices continued to fall, as the CRB index undercut the October and December lows. WTI crude fell to new lows for the year, below the 200 DMA. Natural gas, on the other hand, continued its counter-trend rally and closed just shy of $2.50. Gold fell below $1,600, silver below $30. Copper and the industrial metals were also off, and to complete the commodities rout, grains took some of the sharpest losses of the week, with both corn and wheat falling below $6 a bushel.

Currencies: The U.S. dollar index extended a two week rally, broke through the key 80 level, and closed near the high for the move. The slumping euro meanwhile fell below $1.30. Sterling and the Swiss Franc, the latter still effectively pegged to the euro, also posted losses, as did the Australian and Canadian dollars. The Aussie remains above parity vs. the greenback, the Loonie has fallen below.

Outlook

Last week's U.S. economic calendar was light. Unemployment claims were in line with expectations, and falling energy prices are already appearing in producer prices. Corporate earnings made more of a splash, with a number of downbeat reports and outlooks, and the surprising revelation of JP Morgan's (NYSE:JPM) $2 billion trading losses. The latter prompted Fitch to downgrade the largest U.S. bank. However the greatest uncertainty comes from the implications of Europe's politically charged debt crisis, brought into stark relief by the nationalization of one of Spain's largest banks. Adding to the global concern was China's slowing industrial production.

Stocks: This year is in some ways shaping up to be a reprise of the 2010 and 2011, when strong first quarter rallies gave way to sharp second quarter corrections. To date however, the selling pressure has been relatively modest compared to the two previous years. Last week's trading action saw volume pick up while the rate of price decline fell. In Monday's instablog article I expressed the view that we could expect the S&P 500 to test the 1,340 level, which corresponds to a previous support level. We did indeed see that level tested on Wednesday, and it held nicely. Although the near term trend is down, this can be seen as a positive. Another positive: the small caps have actually started to outperform the large caps in recent sessions.

My short term outlook on equities remains cautious - we have stopped buying and trimmed back a couple of weak positions. However I am using this correction to review stocks on my watch list. Those names that have held up best during this correction are likely to be leaders when the selling pressure runs its course. In general I still like large cap techs, consumer staples, and selected financials. We could also do some bargain hunting in blue chip energy stocks that are now selling at more attractive valuations. But first we need to see markets firm up. We don't want to see the SPX break 1,340 in the short term; if it does it would keep us on the sidelines a while longer, looking for lower prices to put money to work.

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Bonds: The sight of a 2 handle on the long bond, however brief, was a bit disconcerting in terms of the macro outlook, but is a good sign for bond holders who are nervously watching for any sign of inflation. Last week's negative producer price index print should also help to allay those fears, at least in the near term. However with prices at or near all-time highs in many bond sectors, there is not much upside, and yields are…well…let's just say they aren't very attractive. We are holding all the bonds we want, but are not inclined to buy more at current prices.

Commodities: Commodities are in a protracted slump that has extended over a full year. In that time the CRB index has fallen 22%. The index has broken a key support level and is likely to go lower. In the Perspective section above we reviewed the extensive reach of the weakness across commodity groups. With the U.S. dollar rallying we could see continuing pressure on commodity prices. Oil appears headed to the $92-93 level in the short term, and possibly into the mid 80s. Gold appears headed toward $1,500 - the gold mining stocks are back to levels not seen in more than two years. At some point there will be attractive prices and compelling buys, but it's safer to stay away for now.

Currencies: The U.S. dollar index has risen ten days in a row, getting back above the key 80 level, as I had expected. With the developments in Europe, in the longer term we can expect to see the ECB continue to flood the market with euros, driving that currency down and the dollar up. In the shorter term, the last few times we saw a move above 80 in the dollar index, it pulled back into the 78 range. If we see another pull back in the coming week, we can also expect to see some of the pressure lift from equities and commodities. With those asset classes near key support levels, that would be a welcome development, but it is by no means assured.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.