The Coming Bright Red Move In Equities

Includes: DIA, EEM, QQQ, SPY, VGK, XHB
by: Kevin Flynn, CFA

As we stumble into the final days, the question on every trader's mind is - is Santa coming, or the cliff?

My last two columns were warnings that the market was headed lower. With the AAII bullish sentiment indicator nearing an eight-month high, I am tempted to say we are headed lower yet again.

The reality is that next week is too hard to call. Markets are neither oversold nor overbought. Everything rests on policy decision, obviously, and those are notoriously difficult to predict. The market is of course living and dying on cliff rumors, and while it's clear from recent trading action that there is considerable fear of being on the wrong side of the cliff, the fear of not being long at the right moment is greater. The performance calendar is a cruel master.

Consider the mildly remarkable comeback in Thursday's market, when the Dow managed to retrace a 150-point loss on the strength of the news that the House was going to reconvene Sunday night. The remarkable part is not the Dow retracing a 150-point move, something I've seen a hundred times before, but the notion that anyone might seriously have been operating on the assumption that the House would simply refuse to come back to Washington before year-end. This was a news release on the order of announcing that the White House would henceforth be located on Pennsylvania Avenue.

I'm not going to make a prediction on whether or not some sort of extend-pretend deal is reached by Tuesday. A few months ago, I thought that at least an extension would happen on the grounds that no one would want the albatross of the cliff hung around their necks. That part is still true, but not quite the way I anticipated. What each side wants is not so much to avoid the albatross appearing, but to hang it round the neck of the other.

If some sort of postponement is agreed on Monday or Tuesday, expect a rally to follow. Many are predicting a sell-the-news sell-off to quickly follow, and it may, though I don't see much selling on the 31st. The last day of the year is down more often than it's up, but if a cliff deal is reached after four or five days of selling I expect the market to turn up this time around.

However, one prediction I can make is that whatever deal might be reached by the 31st, or a few days after, the real battle over the budget and debt ceiling is going to be an ugly brawl that may well shut the government down, cut our credit rating again and take the market with it. Perhaps not as severely as the 20% decline we suffered in August 2011, because the surprise effect has been lost and many will start buying early this time.

But the budget battle is only getting started. Senator Majority Leader Harry Reid's comments were provocative, and Minority Leader Mitch McConnell did not fail to reply in kind. The House of Representatives is always feistier than the Senate, and the current body is no exception. The lines have been drawn. All the posturing over compromise is no more than practiced indignation over the failure of one's political adversaries to adopt one's own politics. It's become apparent that before any deal can be reached, what both parties crave to do first is have the chance to soundly vote down the other side's proposal. It's going to lead to an ugly episode in the market.

The institutional side hasn't failed to notice this. You don't have to listen carefully to hear all the exhortations to buy European equities (the latest cover of Barron's) or those of emerging markets. What is left unsaid is the clear implication to flee US equities. They are no longer seen as the cleanest dirty shirt, but have regressed to dirty shirt only. That's not to say there couldn't be a rally or a violent two-percent reversal. Just don't make the mistake of believing in it.

2012 will mark the 4th year in a row of positive returns for equities, and it's only fair to say that the bull is getting long in the tooth. From 1930 until the mid-1980s, the stock market was never up more than four years in a row. From 1953 to 1988, the Dow Jones was never able to make is past three. It finally broke through in 1988, and then again during the mighty, once-in-a-lifetime bull market of the 1990s. I don't think that it's wise to read everything out of the past, but you might want to think about history.

And credit. Interest rates fell throughout the 1980s and 1990s, a trick that won't be repeated for a long time. In addition, it seems likely that we will be managing the deleveraging process for years to come, much as Treasury was doing in the years following the second World War. It isn't the most promising environment for a fifth year in a row. I'm not making predictions for 2013, but it's going to be a difficult start. A troubling aspect of arguments for another up year is that they all seemed to be based upon multiple expansion. The last time I heard this reason making the rounds was 2007.

On television, on radio, online and doubtless in Friday morning in print is the news that "new home sales are at a 2-year high." If there was ever news that you wanted to take with a grain of salt, that might be it. I'm not so sure how well November is going to survive revisions, because the data certainly looks noisy. The West reported its sharpest seasonally-adjusted drop in two years, which didn't then presage an uptick in new home sales. On the other hand, the South reported the biggest increase since last November, and home sales were rather quiet the next few months after that. Eventually the warm weather and rising stock market led to a surge in February, but I don't think that either happens in 2013.

Yet there is no doubt that new home sales are steadily improving. The trailing 12-month total of actual sales (364K) is now at its highest since June of 2010, nearly 2 1/2 years ago. But it wouldn't stun me to see the seasonally adjusted total (377K) revised back to July 2012 levels, which were only slightly lower (373K). On the other hand, the current actual 12-month total is lower than every single month before July 2010, probably going back to before World War II, though the records only go back to 1963. November 12-month sales are 35% lower than December 1963.

If you want to be an optimist, it would certainly appear that there is an awful lot of upside in housing. There is also an awful lot of room for near-term disappointment in homebuilder stock prices, with the XHB up over 50% this year. I don't see the budget battle giving the economy a lift in the first quarter, and while I do expect employment to improve in 2013 overall, personal income growth is currently weak and bank lending - still the crucial factor - is still very tight. I would be wary of this sector in the first quarter, as the combination of cooler weather and District of Columbia hot air could play havoc with sales in the early part of the year.

You should also take the weekly claims data with a grain of salt, as the Labor Department observed that 19 of the 50 states, or about 40% of the total, sent in estimated data. In unadjusted terms, the actual number of layoffs is increasing, as they always do at this time of year. It's hard to get an exact read, but the year-on-year improvement in claims seems to be under pressure. It's a trend worth watching.

You've surely read that Christmas sales are the weakest since 2008. It isn't a good sign. Neither are 150-point reversals around market peaks. That kind of choppiness tends to presage a downturn. The budget battle will mean more caution in consumer spending and keep corporate investment spending in suspended animation until a resolution is reached.

The economy isn't in danger of collapsing, but it isn't robust either and the coming battle should take us down below the current sub-2% GDP run rate (Q4) to below 1.5%, if that. There will surely be rally breaks, but this market is in for hard times. Next week I will write about where eventual support may lie, but an eventual break is imminent. Don't buy the dips, sell the rallies. If you can't go short, count your cash instead.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.