A Disturbance In The Force

Includes: IWM, SPY
by: Kevin Flynn, CFA

Was that a disturbance in the force on Wednesday? It might have been, though it's still too early to leap to conclusions.

With 2013's outsized gains, there are some conflicting interests in the stock market this year as we head towards the finish line. One group I've written about before are institutional investors such as pensions and endowments, who have a rebalancing need after the strong equity performance in 2013. Like everyone else, they want to sell high, but with a natural need to sell are going to be quicker to let go of positions when trouble brews.

Then there are the retail investors hoping to postpone some taxable gains into the new year - I suspect that there are a considerable amount of stop-loss orders lurking in the market (and there will probably be more Thursday morning). They would like to wait until 2014, but not at the price of giving back too much. Most mutual funds are already into fiscal 2014, so they're not too concerned with any tax issues, but they are keeping a keen eye on the calendar-year performance rankings. With three weeks left to go, it's far easier to get into trouble than it is to pull a rabbit out of the hat.

I am sure I will not be the only one to grimace (some will cackle) at the faintly, perhaps completely ridiculous position the Federal Open Market Committee has put us in, with the Dow Jones average racking up triple-digit losses at the prospect of a very modest budget deal. I've no doubt that most of the governors will simply roll their eyes at that crazy stock market. They may get another chance tomorrow - although December retail sales seem to be off to a fairly slow start, the November data due Thursday morning could have the stock market selling off further if the numbers beat consensus on the ex-auto, ex-gasoline side (+0.2%).

I don't want to make too much out of one day's trading. Consider that if the stock market really sets itself up for a taper next week and the Fed ends up deferring the decision again instead, prices could ride a big sentiment reversal wave higher into the end of the year. Even so, a day like Wednesday, when equities ought to be celebrating instead of slumping, does feel like one of those days that people point back at later as a key indicator of dysfunctional market dynamics. Or when Fidelity is announcing at the same time that it will accept bitcoins in IRAs.

It could take some time yet. The Wall Street Journal ran a puff-piece scorning the notion of a bubble, one that included an eye-opening comment from one CIO who dismissed bubble-worriers as "part of the healthy voice of dissent that is necessary to fuel early stages of an extended bull market." Early? This bull market turns 60 months old in three months time. If there is no 20% correction soon, it will move into undisputed possession of fourth place for the longest bull market since 1929. We will have to pass the 1990-2001 bull to be in the "early" stages now. It's been 26 months since the last 10% correction.

Mark Hulbert has been anxious of late, writing the other day about a potential triple-top for equities. When I set this against the latest piece from Bill Gross and the almost-everyday observation that whatever one may think, there is no discernible catalyst for breaking up the momentum trend, it brings several thoughts to mind.

My experience is that a broad, increasingly public market consensus that there is no catalyst for a correction usually comes about after an extended period of loosening credit - otherwise we're not talking about it - and about three to six months, on balance, before some event signals that the party is over.

As for loosening credit, high-yield bonds have been at ridiculously low yields for some time now, bond issuance has broken all-time records for two years, margin debt is at all-time highs and the Chicago Fed observed that financial conditions are as loose as they've been in twenty years.

The "no-catalyst" talk is familiar enough - I heard it in the spring of 2007, and indeed before every recession prior to that since the 1970s. Often the catalyst is visible enough, but is simply denied by the Street in the initial going. I can't remember a Fed tightening cycle that wasn't accompanied by an initial rally and a lot of sage counsel that the central bank was on the job, the market was already well-prepared for this, there is Nothing To Fear.

Keep that in mind, because one thing the stock market loves to do is the opposite of what's expected - for a while, anyway. I can very easily imagine a big rally getting going after a potential Fed mini-taper this month, the kind that starts with a short-lived sharp drop that takes out all the stop-losses that were set "just in case," and then follows with a massive upside reversal. Hulbert's point about triple-tops being dangerous is well-taken, but the market rarely stops right at such levels. It's just too easy, too wimpish. More often than not, we have to have the break-out high first (which we have recently done), the one that lures in the last wave of pigeons. I have been writing that we are halfway up a blow-off top, and one has to allow for that last wave of sentiment.

Perversely enough, the trigger for a decline could be a mildly improved economy, one that validates the bullish pundits insisting that the economy is really better than it is - and has the Fed moving in the other direction. I don't really see improvement in the data yet, but even with jobs being a lagging indicator, and supposing that the BLS has been overestimating by a healthy amount, there ought to be some knock-on effect from increased employment levels that were only averaging, say, 150K a month (though it may soon be crushed by over a million people falling off unemployment insurance at the end of the year).

Most of the projections I see for better times are based on soft talk about an increase in business "confidence" and "the need to invest," the latter tale a familiar one that I have yet to see so late into an expansion cycle. Still, Mohammed El-Erian has the economy picking up to around 2.5% next year, and Pimco has been pretty good with their calls in recent years.

And the data might let us think that things are better than they are. For example, last week's employment report turned a 3,000 monthly estimated decline in actual manufacturing jobs into a 27,000 seasonally adjusted gain. In 2005, a 6,000 job November decline was reported as seasonally adjusted decline of 5,000. The trend of laying off seasonally laying off manufacturing workers towards the end of the year was probably exaggerated last year by the big pause in front of the budget slowdown. I suspect that strong auto sales keeps them from slumping too much this time around, but it's hard to bring out the cake when one considers that the 2007 October-November decline was a third the size of the 2006 edition. Employment is the last to know. Credit conditions in autos can't get any looser - 2014 will probably see the peak in the sales rate.

I don't see any real sign yet either of the long-awaited increase in business investment that is supposed to come about from all the cash that corporations have (largely held by a relatively small number of big companies). To smooth out the effects of last year's fourth-quarter pause, I look at two-year annualized growth rates in business purchases of capital goods, and it has been falling steadily, now at only 3.5%. With insiders selling stock at record levels to their own companies borrowing the money to do so, corporate executives don't seem to be acting like they are expecting a big boom.

Maybe we won't need much a lift in capex, or maybe we'll get a mild one as employment peaks. It's hard to say at this point. What I can say is that Wednesday's decline took us out of overbought territory in the short term, though the S&P is still up there over the intermediate and longer time horizon. The Russell has fallen off more sharply and is approaching oversold conditions tempting enough to take a stab with the iShares small-cap ETF (NYSEARCA:IWM), though it is still far above its 200-day average.

Since the Fed passed on easing in September, I've thought that the high for the year would come in the last week of December, especially after skating through some traditionally weak periods. But the Fed meeting next week makes me uneasy about sticking my neck out - guessing policy decisions has been a sucker's game with this Fed, and Bernanke has wrong-footed me too many times. This is still not a cheap market, regardless of what datum someone drags out to prove it's not too expensive - keep in mind that we're all essentially long on sentiment at this point, and it is a very capricious master.

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.