Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Market Correction?

|Includes:SPDR Dow Jones Industrial Average ETF (DIA), QQQ, SPY, TIP

Is this the start of a market correction? While the talking heads and analysts try to make heads and tails for the huge decline and fingering pointing at everything from Russia to the Gaza Strip battle. Frankly, I think the talking heads have it wrong, very wrong. As I have said all along this is a Fed fueled market, it has ignored the Ukraine, higher oil prices, Gaza strip, and even a negative -2.9% GDP. So all of a sudden one day it decides to pay attention to it?


Reason and Logic

Thomas Paine said, ""The most formidable weapon against errors of every kind is Reason. I have never used any other, and I trust I never shall." I too try to apply this methodology and to remain objective regardless of my ideology or bias. It is certainly a difficult task, but I think if you follow the reasoning and logic, everything becomes clear.

As I pointed out at the beginning this is a Fed fueled market and has been. If we look at every announcement of QE, from QE1 to QE3 the market rallies. At the end of each QE program the market sells off. Logic would dictate that if you inject billions of dollars per month (over a trillion a year) into the market, keep the short-rates at zero, buy the excess bonds and mortgage back securities, and allow for increased leverage the markets will rise (inflate)and take that away and the market sells off.

I believe this has become the single largest driving force in the U.S. equity markets and in many cases the global markets via spill over. The western central banks (BOJ, BOE, ECB, and FED) have collectively printed trillions of dollars, lowered interest rates, and bailed out the lending institutions - while fueling leverage into the bond market. The fact remains the biggest buyer in gross Treasury bond issuance and mortgage back security (MBS) issuance has been the Federal Reserve, in fact they are not only the biggest buyer but are now the biggest holder.

At some point this has to end, as it has with each QE before. While the Fed has announced and tapered their purchases, they are still purchasing 10s of billions per month and still remain the largest buyer. A big part of their reduction on bond purchases is simply the fact the supply of government bonds has declined, thanks to the sequester and shrinking deficit as revenue increases. Remember deficits are reduced not just by a reduction in spending, but also the rise in tax revenue. The US Federal Government has seen deficit reduction from both, a rise in tax revenue and also a sequester. I am sure the Fed would NOT be able to taper or taper as much if this were not so.


Why the Sell Off?

So why the market plunge yesterday? As noted earlier the market has ignored a rather volatile geopolitical environment; Ukraine civil war, plane shot-down, Israel-Palestine conflict, Iraq internal conflict, oil prices moving higher, and a host of issues. Anyone of them, in a traditional free market environment without the heavy hand of Fed intervention, we would see order flow move into the bond market - a safe haven. Because in a free open market, the treasury market would have interest rates at the long-end of the curve that is more reflective of the economic environment, not artificially low and set at zero at the short-end of the curve. The Fed intervention kept money flowing into the market, despite the geopolitical volatile.

We saw a horrible GDP in the first quarter at -2.9%, in a normal market condition we would see the market sell off sharply as money would again flow into bonds, seeking safety. However, the treasury market pays nothing at the short-end and real returns are negative even in longer dated maturities once we back in inflation rates. So no, bonds are not a safe haven, they are money losers, all because of Fed policy. So again, money stays in the equity market.


So What Changed?

If I am right, which logic would dictate, then what changed? Simple, the GDP at 4% coupled with the change in tone of the FOMC statement is what changed.

The GDP at 4%, which would seem like good news and is (if real) for the economy, is bad for the market. Why, because IF the economy is really growing at that rate (which I dispute), then it would mean the Fed is more likely to become MORE Hawkish and certainly sooner. The GDP at 4% followed a slight change in tone in the FOMC statement, which included concern about the recent rise in inflation (as measured by the CPI). This morning Fed President Fisher was on CNBC, whom many thought would dissent (vote against) and did not, said he both felt that other members were "digesting" his view on policy and he agreed with the new wording / tone change about the concern in the rise of inflation. In fact he went as far as to say the concerns about DEFLATION have abated.


Good News is Bad News

In essence, good news is bad news. Think about that for a second, when we have become reliant on what even Fed President Fisher calls "enabled by uber-cheap money ", well then when that flow of "uber-cheap money" stops, the market sells off.

So a combination of a strong GDP 2nd quarter of 4% coupled with a FOMC statement about a rise in inflation, means those in the market are going to get out before rates go up, take profits, and most likely sit on the sideline.

This is nothing new, each time before QE ended before, there was talk about the Fed raising rates and the economy improving. The "uber-cheap money" of QE stops and investors exit the market. We certainly should NOT be surprised at the market response.


GDP really 4%?

While I am firmly in President Fisher's camp that we need to end QE and raise rates, I am also not a blind believer in the 4% headline GDP number yesterday. Even without ANY revisions and even IF the GDP at 4% is real (all of which I doubt), my concern is that 1.66% GDP points were from inventory loads, that is over 40% of the GDP rise. If we look at the DEMAND side of the equation as measured by earnings and domestic retail sales, there is NO WAY that we will see repeated inventory loading to meet demand, because the demand is certainly not there. Even the consumer spending portion of GDP which was up, was not up enough (even without inflation adjustments) to justify a continual inventory load to meet Demand. So at best we are at a 2.3% GDP growth, while not bad, it certainly is not nearly as robust as the headline 4% would have us believe. So I believe the market has read a little TOO MUCH into this GDP number and it will be revised and even if not we will see a significant slowing of the GDP back to the 2% range in the 3rd quarter.

Chart of GDP and Personal Consumpiton Expenditures


Labor Report?

The GDP number is not the only thing to consider, the Labor Report is the most highly watched number as jobs continue to be the biggest factor when it comes to elections and also Fed policy.
Prior to the Labor Report the pre-market futures were down sharply, Dow Jones futures down about 100 points. Expectations were for 233,000 jobs in July and unemployment expected to fall 6%. However, the released disappointed this morning, jobs only came in at 209,000 and unemployment (U3) ticked up 6.2%. The U6 rate ticked up to 12.2%. The participation rate increased slightly, most likely the cause for pushing up the U3 unemployment slightly. It will be interesting to see how many of the jobs were created by part-time jobs, but I will wager it will be significantly more than full-time, if the trend continues.

This is bad news, but good news. Why would I say that, well if the job market is not as strong as we thought, then it has muted the tone of the GDP and the possibility of the Fed raising rates. Remember the Fed, especially Yellen, focuses on Job Creation and lower unemployment, if both of those are falling short of expectations, do you think they are inclined to raise rates or end QE all together? Certainly not - in fact if the Labor Market remains weaker, odds are (despite GDP) they will continue with zero interest rate monetary policy for longer.

At the release of the weaker Labor Report the Dow Jones futures rallied sharply, almost 100 points from their low, in the course of a couple of minutes. Again, a reversal in the perception of the market's opinion of any changes to rates by the Fed.


Market Correction?

Again, in the long-run I believe this market is setting up for a significant correction. My belief is based on the following; leverage (margin) reaching all-time highs, low liquidity/volume, weak REAL job growth, REAL high unemployment (U6), REAL inflation pressures, weak consumer wages, weak domestic earnings top-line revenue, and increase in housing debt and prices.

So how come all these things have not impacted the market? Well, I would argue just like a negative -2.9% GDP, Ukraine, Russia fall-out, Israel, Argentina default, and a rise in oil prices haven't brought any pressure to the equity markets. The market is ADDICTED to "uber-cheap money". In fact Fed President Fisher made it clear that it has "enabled" the equity markets.

So the market is in a battle, fundamentals vs. the Fed policy. For now the Fed policy continues to win and any hint of it ending would send jolts of volatility into the market as it has repeatedly after QE1, QE2, and now at the ending of QE3. However, I don't believe the Fed will raise rates as Fisher suggests, he is the LONE VOICE in a room full of Keynesians.


The End Game?

The end will come, but it will not come from a Fed controlled exit, as Fisher would like and I agree would be the less painful way. It will end not by Fed design, but by the laws of Supply and Demand. Yellen and her Keynesian brethren would not ever give up accommodations, it is not in their nature. Sure they could ease off accommodation but it will be too late and at best tepid moves.

The laws of Supply and Demand will always win in the end and the Fed will not be able to stop that tide when it comes. Whether it is a catalyst from a foreign nation liquidating treasuries or forcing trade in non-US dollars, or a lack of faith in creditors, the catalyst will not matter. Just like yesterday, when investors head for the exit it will accelerate.

Fed policy is buying time only and is inflating assets, it is not solving a systemic problem and can't. It has masked the true problems in the nation and that is a failing fiscal policy that is fraught with debt ceiling limits, expansive government programs, horrid tax code, and general trend towards Socialism. We have not and will not address the trillions in debt and the 100s of billions we pay in interest, the Federal Government continues to ignore the math and frankly the Fed can only buy so much time.

I really wish that was not the case and we had more people like President Fisher, Ron Paul, Judd Gregg, David Walker, and others of that ilk that have served in Congress, Senate, Fed, and Treasury that understand the math and risks of debt. However, the political winds are blowing towards the likes of Elizabeth Warren that wants to turn the Post Office into the bank, coined "You didn't build that!", wants to forgive Student Loans, and wants to expand government subsidies for housing and welfare. I personally believe she IS going to run for President and will beat Hillary in a Democratic Primary. She is a new face and the young people flock to her as she fuels the entitlement generation.

Yellen is her kinsman and with Yellen running the Fed and Warren as President, there will be no hawkish Fed policies and certainly no fiscal responsibility or accountability. All of which means it will end badly.


Conclusion.

I think yesterday was very clear how fast this market can turn when and if the Fed actually does take action to raise rates and end any accommodation. Good news remains bad news for the equity markets and the weak Labor Report this morning was a sigh of relief that the "uber-cheap money" will continue to flow for a little longer.



Support & Resistance

INDU 16,400
Yesterday I stated this was the support range, we saw the pre-market futures get down to 16,400 and even below before the bounce on the Labor Report. Resistance will be at 16,800, the previous first support area.

NDX 3,900
We didn't hold the 3950 yesterday and hit that secondary support at 3900. I think we will hold in there and slightly bounce today heading into the weekend.

SPX 1920
As pointed out yesterday this is the bottom range support and we hit that this morning in the pre-market futures, before bouncing. This again is a key support level and if we can bounce slightly today and stay above it - I think we will be fine heading into next week. The VIX popped, as it should, but I think will come off and move back into the low 15 range and even into the high 14 range this morning if the market can hold above 1920.

RUT 1130
As I have been warning for the last couple of weeks the 1130 range is key. If the broad order flow is not flowing into the market, which it didn't seem it was, then the narrower indices like the Dow Jones will fall sharply. We didn't hold 1130, and slipped down to 1120 and the market came tumbling down. I don't think the RUT has too much farther to fall if it can't hold 1120, perhaps 1110 or 1100. I believe the RUT gives us better resolution to the appetite of the equity markets and the summer has shown (as measured by the RUT) that money is not flowing into the equity markets as we have drifted from 1200 to 1130.


Be Prepared!

No doubt we are getting to some critical levels and if we don't hold, we could be in for a rather large correction. However, I don't suspect that we will have a huge correction this week or next. That is not to say the possibility is zero, there is always a possibility. However, I think the Fed's lack of action, a weaker labor market, and a GDP we all know is not truly reflective of the actual economic conditions means we just saw a knee jerk panic and everyone will calm down soon. That doesn't mean you should not be prepared, you should already have on your hedges.

Why no correction now? Well what are you going to do with your money, buy treasuries? Of course not, Fed words are NOT Fed action no matter how much the market would like to think so. Interest rates are not going up and even if they do, they will not until 2015 and at most it will be a 25 bps.

The catalyst for correction, in my VERY humble opinion, will not come from the Fed because I believe they are less incline to take Hawkish action (Fisher is one member and not in charge), but from some larger event that will most likely come from China or perhaps the BRICs. If the hostility with Russia continues we could see a stronger unification from the BRICs against the west. The BRICs have already started their own "world bank" and they are NOT using US Dollars. Oil is already trading with BRIC nations in other currencies than dollars. It only takes one huge policy change from the BRICs to crack the dollar. Something like BRICs force all trade with BRIC nations into their reserve currency; BRICs collectively sell their US treasury holdings, anything like that could spark a catalyst that even with all the Fed accommodation will not help stem the tide. I think an event like that would put the Fed into the position of actually buying SPX futures and perhaps even directly buying US stocks. Unfortunately is history is any measure, these economic embargoes, sanctions, and currency battles usually bring forth war - and no one wants that.

We are already seeing a rise of US international corporations positioning to leave the U.S. Tax-inversion strategies will only increase and even if the President is able to halt that, foreign companies will just buy U.S. companies and move them out. The tax-inversion strategy is not just about taxes, it's about currency and regulations.

If China and the BRICS collectively is your biggest consumer market, if they have more tax advances, and more welcoming regulatory market - you can bet companies will move and are moving.

Disclosure: The author is short SPY.

Additional disclosure: We have on P/S in various indices dating out into the third and fourth quarter.

Stocks: DIA, SPY, QQQ, TIP