Why You Need To Stay On The Sidelines

Includes: DIA, IWM, SPY, VGK
by: Kevin Flynn, CFA

Despite the market moving into a short-term oversold position, I'm keeping intact my position of May 16th that it's still a good time for avoiding equities. The situation is fluid, however, with many moving parts, and I should point out that despite my sideline stance, June is very rarely a crash month (when markets do melt down in June, flee).

Given that encouraging thought and the market's weak relative strength, it's legitimate to wonder about stepping in for a trade. If the May retail sales report surprises to the upside, markets could put on another one percent day, as happened with the jobs report last Friday. The April upside surprise in May led to a much more sustained rally, but the backdrop has changed so much since that time that the upside is probably limited until either the FOMC announcement next week or the market can get more deeply oversold.

Two important changes are the calendar and short interest. The latter hit a short-term peak on April 30th, using the official NYSE data, and quite possibly had increased further by the eve of the report. Certainly the parabolic nature of the move in the days following the jobs report was a telltale sign of a formidable short squeeze. The result was that by the May 15th report, short interest had fallen to a 19-month low, removing an important source of buying power.

So far as the calendar goes, if it were the first quarter traders would be leaping in to buy at the current oversold levels, unless there were some sort of major crisis underway. But we're entering the summer months, when such trades are less reliable and the lower bound for relative strength, for example, drops to around 30 instead of 40. .

A third problem is Japan. It's hard to put a finger on the exact size of it because so many of these trades are shrouded in secrecy, but there is a lot of buzz on the Street that volatility in the yen and Japanese equities has been significantly disruptive to a lot of strategies, leading to forced unwinds and selling of collateral assets, including Treasury bonds and US equities. When the Bank of Japan emerged from its latest meeting with a stand-pat position, it left the situation vulnerable to further pressure.

The volatility in the Japanese markets has been simply tremendous lately, making it difficult to have much confidence about a US-based trade in either direction. I certainly wouldn't get carried away with shorting at this point, either, though there is probably a general reluctance to do so anyway in the face of the Fed meeting next week. Trying to guess that outcome could be quite expensive.

A further dynamic that is more absence of safety than danger is the lack of capitulation. Traders are clearly nervous about the short term volatility, but there still appears to be a lot of confidence in the intermediate and longer-term outlook. Bloomberg ran a fairly effusive piece over the weekend in the wake of the jobs report that was laden with prose and quotes gushing over the economy and outlook. However you may feel about that, it isn't a sign of seller exhaustion.

The macro-economic backdrop has not been supportive, though stock markets do tend to ignore macro developments unless they are favorable or markets are badly frightened. The World Bank lowered its outlook again for 2013 Tuesday night, which won't have a long-lasting effect but left overnight futures weak. Those who've been insistently quoting forward PE's as a basis for saying the market is cheap may need to reach for Plan B: Those estimates are not going to come true anymore this year than they have before.

Take a look at this graph that I've been putting up recently on a monthly basis, showing the rolling 12-month year-year change in sales by US wholesalers:

source: US Commerce Dept, Avalon Asset Mgmt Co.

It's not improving. I find this trend worrisome, and indication of both a lack of real confidence by business and a lack of fixed investment. Yes, the small business confidence indicator rose this week, but that was on the heels of the big market move in the first half of May. Watch what people do, not what they say - you get much better information from seeing how people have positioned their money than by what they may tell a survey.

The biggest question mark of all, I need hardly say, is the Fed meeting next week. The markets have been far too fixated on central bank actions, which is not a healthy sign but can take longer than one might think to come undone. I think some of the faith in them has been shaken a bit lately, but it's a process that could take months to unfold.

Clearly Alan Greenspan is worried about the faith in the Fed, as he indicated in a CNBC interview last week when he expressed concerns that fears about the Fed balance sheet - as well as the size itself - might lead to a situation where inflation and/or rates might get into a spiral that would be difficult for the bank to control.

Certainly the last point is one of the most contentious in the investment community, and Greenspan's words couldn't have gone unnoticed within the halls of the bank. All of that said, Bernanke has often led the Fed in directions that has surprised me along with many others in the trade, and I confess to having no strong feelings about what the committee may do - or rather say, as it seems most unlikely that the Fed will stop on a dime this month.

It's certainly a valid argument that the economy isn't strong enough that the Fed needs to start withdrawing, as many have made, the jobs report notwithstanding. Yet it's also valid to say that the Fed has to pull the trigger sooner or later, and a little early may be far less harmful than a little late. The market is currently only about 4% off its all-time high, and can certainly withstand a move to the bottom of its long-term range (around 1470). Nor is it possible any longer for the market to be taken by surprise.

Yet the Bernanke Fed has overall seemed rather afraid of the markets ever since the crash, so my guess is that the FOMC will try to thread the needle. Kicking the can down the road has been one of the most popular stratagems in the last four or five years, so maybe it's the Fed's turn to try it again.

Even so, one can't rule out the possibility that Bernanke comes out with guns blazing, nor announces a mild taper. Some have complained that Fed buying has constrained the supply of Treasury bonds available for various strategies, including carry trades, but does that bother Chairman Ben? He's caught between the career-making fear of premature tightening (one of his major claims to fame being the assertion that the Fed tightened too early in the Depression, thereby prolonging it), and the legacy-threatening blowback of over-reaching to a disastrous ending of runaway inflation, or interest rates, or both.

My vote is for taking some money off the table and getting on with letting the adjustment process start, but I'm not on the committee. If the economy and market can't withstand the Fed only buying $40 billion of bonds a month, then I don't see that quantitative easing is really doing anything but keeping asset prices hooked up to a slowly failing respirator. If you didn't see the John Mauldin on-line seminar "Investing in the New Normal" the other day, it's worth watching just to hear the points about the necessity of adjustments made by Pimco's Mohammed El-Erian and Fusion IQ's Barry Ritholtz.

In sum, there's no need to rush into this volatility - wait for direction from either the Fed or overextended sentiment.

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.

Additional disclosure: I am long and short the market with a net long position.