Time To Start Fearing For Equities

Includes: DIA, IWM, IYT, MDY, SPY
by: Kevin Flynn, CFA

I fear for this market, I really do. I also fear for the pigeons flocking in for its last stages. They will enjoy some gains for a few months, and then get plucked all over again. How long we can go on like this and maintain a real stock market, I don't know. Volume has already been mediocre for this rally, leaving me to wonder if there will be any at all left to accompany the rise from the ashes of the next rebirth.

This is not an article about the end of all things and the necessity of going to gold and diesel fuel. It's an article on the growing likelihood of an increasingly contrived rally coming to a bad ending. I didn't believe in the likelihood of such an outcome as recently as a couple of quarters ago, but we seem to be headed for it now. However, if it's any consolation, there's a little time left before the real pain starts.

Let's look at the technical picture first. Short-term indicators suggest that markets are short-term overbought, but not yet egregiously so. That's the good news. Intermediate indicators suggest that all of the indices are overbought: The S&P and Russell are the most overbought in over two years, the Dow a little less than that (and the transports, which have been looking suspiciously manipulated to me the last week, are the most overbought since 2006).

My long-term indicators say the major indices are the most overbought since 2007. It suggests a correction of greater than 10% is coming, which looks about right to me. It's not a law, as the final year of the tech bubble saw the markets stay inhumanly overbought for over a year. But I don't see us entering a manic bubble in 2013. If ECB President Mario Draghi cuts rates on Thursday - and I think that there is a chance he will - the prospects for bubble formation would improve.

The longer indicators are not such effective timing devices for the very near future. The combination of all of the above - as well as the weakness in the price of oil - do suggest that some kind of modest pullback is imminent, but any near-term pullback could conceivably end up being a wash.

That is to say, we might lose a couple of percent first, or we could rise a couple of percent more first (Draghi does cut rates and Friday jobs are above consensus), and then pull back. Absent a big political event, I am sticking to my position that a strong pullback is unlikely this month. Indeed, as we move through the final month of the quarter, the chances improve that performance laggards will rush in to buy dips.

After the end of this month, I think you might do very well to go to cash and short-term bonds. The market is likely to have been up over ten percent, and you could probably have a good year staying on the sidelines after that. I don't know when the ten percent-plus correction will come - my guess is between mid-April and early May - but it doesn't do to put too fine of a point on these things. You might try scaling out a little at a time on every up day after March 31st. If you're the quarterly sort, sell the lot on the last day and don't come back until the headlines are terrible and Jim Cramer looks really, really frightened.

My fears for the market extend beyond a handful of technical indicators, you may or may not be relieved to know. A combination of things has led me to this point over the past few days, unfortunately coinciding with some heavy-duty research and reading.

To begin with, I suggest you check out these interviews with Charles Nenner and Stanley Druckenmiller. Nenner worries me, because as a technician he's been uncomfortably good. I am much more of a value-fundamental analyst than technician, but I also know that markets only converge with fundamentals over long periods - often on the way back from extremes. I also believe that when strong economic currents are absent, which certainly includes the present state of affairs, the markets move more on their own internal rhythms than at other times.

Bloomberg ran a headline misquoting Nenner as saying the Dow would fall to 5000 this year, but what he said was that it might get there by late 2017. More important is his opinion that the cycle tops out this year and will start to move down before year-end (some of his indicators have already started to move down). That dovetails with several other issues that concern me, though on the brighter side, it also fits with my notion that the market peak probably won't come until the fall.

Druckenmiller - who has the honesty to admit that if he were still running money, he'd probably be playing the game of chicken-long like everyone else - has a lot to say in his interview, and his very good track record recommends him. One point I will repeat here ties in with the current fad for saying that stocks are the only game in town, due to ZIRP (Zero Interest Rate Policies, an anagram you will see a lot of this year). In short, ZIRP has created an environment where the consensus is that stocks are a better deal than bonds. Yet bond prices, Druckenmiller observes, are artificial and have been rigged by the central banks, something that we tend to forget in our excitement. It's the same type of fallacy that led people to buy houses in 2005 for 50% more than they sold for five years earlier.

That concerns me. When Alan Greenspan left rates at 1% in the early part of the decade, he did so at a time when the economy was still weak and housing the only decent asset class standing. I didn't think it was so bad in 2003, but by 2005 both Druckenmiller and I had come to the same conclusions about housing. I was baffled every month as to when the Fed would send out a directive urging tighter residential lending standards. I suppose it was politically too difficult.

It became clear that the phenomenon of very low rates for an extended period encourages too much speculative financial behavior. The biggest problem was over-leveraging in mortgage bonds, obviously, but it also encouraged loose bank lending, progressively weaker credit standards and inflated stock market values.

Alas, the progressively weaker credit standards are back. Junk-bond yields are at all-time lows, and this year's pace is already 36% ahead of last year's record issuance of $433 billion. We have an anemic economy and an expansion nearing its end - how are these bonds going to fare when times get rougher? I don't even want to put up a chart of the expansion of central bank debt, it's too scary to look at and I don't know how it plays out. But I do know that central bankers are not good at recognizing bubbles, nor policy limitations, especially when the economy or politics are such that one does not want to see them.

Extraordinary times call for extraordinary measures, but when the latter are left in place for too long, they have dramatically eccentric effects on asset prices. The double-digit inflation of the 1970s and the housing bubble are two good examples, but economic history is littered with many more. All unusual policies have a shelf life, one that their maker has never been able to see in time.

Yes, I did say that the expansion is nearing its end. One of the reasons I fear for the market is the media-fueled perception that it is just the opposite. When the Dow roared through its record on Tuesday, based mainly on the trading perception that today was the day, I shook my head. I've seen this kind of insouciant move enough over the years to recognize the flash as the writing on the wall. CNBC headlined its website page Wednesday with the same news story they've been running nearly every March for the last decade - the economic recovery is at hand.

The evidence cited for the story consisted quite literally of the Beige Book's report that all twelve districts reported "modest or moderate" growth, and - mirabile dictu - the outlook of 1) a Wall Street strategist; and 2) a Wall Street economist. The sad part is that the Beige Book was actually a bit weaker than last month, enough for the normally optimistic Econoday website to opine that it would "keep the hawks at bay" at this month's Fed meeting.

The ISM non-manufacturing February survey came out this week at 56, a little above expectations and more "proof" that the US recovery is "finally gaining traction." The business activity index came in at 56.9, but in February of 2012, it was at 60.3. Then it fell to 52.4 in June. In February of 2011, it was at 63.5 before another eight-point decline to 55.1 in June.

My guess is that it falls to about 50 this June. We are getting the usual mild rush from new calendar budgets, but not more than that. In case anyone was listening to company earnings in January and February, most corporations are not planning to expand their investment spending. Their focus is on cutting costs and buying in stock. The long-awaited uptick in business investment spending in January was nice, but I am not so naive as to take one month's mild bounce and extend it indefinitely into the future.

Yet that is precisely what the business media is doing, despite the recession in Europe, despite the China slowdown and its debt bubble, despite the universally acknowledged central bank-invented level of stock prices. Their stories spill over into the mainstream press. The level of expectation is going up, yet as Nenner observed, the recovery hasn't been as strong. Unemployment is still near 8%, the participation rate is still near historic lows, and while the investment-led housing recovery may be real, the size of its strength is being greatly exaggerated.

If the economy does start to slip - and no expansion lasts forever - stocks may indeed slip to a lower level. I'm not ready to buy into Nenner's prediction of Dow 5000, but his overall logic is simple enough (if it's any consolation, he sees a huge bull market after 2017). So is Druckenmiller's. The US economy isn't so strong, the global economy isn't either, and you cannot run extraordinary policy forever without some kind of reaction. Druckenmiller's view is that the payback may be worse than 2008.

Despite the above, March is still a favorite to be up rather than down. Two central bank meetings are likely to keep things intact, as well as the aforementioned buying of the dips to catch up. After that, it will be grim for a time. CNBC made much of Warren Buffett's assertion this week that America will always come though in the end, but neglected his maxim about being fearful when others are greedy. It's time to be afraid.

Don't let yourself get pressured into new longs unless you know you're capable of bailing on them without hesitation. Avoid equities until we've seen a pullback or you're willing to do a pairs trade, like shorting 70 dollars of the MDY mid-cap ETF for every 100 dollars of long the SPLV (low-volatility S&P ETF). If taxes are an issue, sell some covered calls now and leave yourself room to sell more if the S&P 500 gets to its new high this spring.

Disclosure: I am long SPY, IWM, MDY, SPLV. 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.

Additional disclosure: I have covered calls against positions in SPY, IWM and MDY. I am also short the IYT.

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