A Deceptive Top In Equities

by: Kevin Flynn, CFA

A quirk of the stock market is that it likes to look past bad news towards a rosier future, then celebrate the rosy future again when it arrives. It's just the nature of the beast, the stock market being a place of built-in optimism at most times. Thus we are positioning for a scenario in which prices overreact to the long-awaited rebound in economic data, a rebound we may not see any of before April, especially if the releases are duly underestimated in order to produce those headline-making estimate beats that make the stock market go.

Be careful, though. The accelerated action in retail stocks of late - the XRT retailer ETF is up nearly 10% this month, though still down on the year - is certainly an indication that traders are already building in a weather rebound. So are the big bounces in the other major indices. The celebratory period may be briefer than you think, as Wall Street does tend to buy the rumor and sell the news.

Indeed, rebound fever has gotten so pervasive the last week or two that even die-hard momentum guru Jim Cramer has been on air of late fretting about stocks that go up for no apparent reason, other than not filing for bankruptcy. He is also one of many, including myself, that have noticed the narrowing of trading money into fewer and ever-more expensive names, like Facebook (NASDAQ:FB), LinkedIn (LNKD), Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), et al.

I am also one of the (dwindling) many who think that Facebook overpaid for WhatsApp, despite the growing chorus of voices wisely observing that had the latter come public, it would be even more overpriced. That is 1999 logic, as Cramer himself observed, he being one of the few that publicly does not want a rerun of that year (though most momentum traders wouldn't mind it a bit - live for today and let someone else worry about tomorrow).

The result is that some of the usual high-beta suspects - small caps and mid caps - have become short-term overbought, in spite of the inability of the S&P to close at a new high. The latter phenomenon has kept that index from moving into overbought territory (short term, that is - long term, everything is strongly overbought) and actually worked to the advantage of the higher betas by allowing them to keep moving up (the IWM has been up 14 of the last 15 days), yet keeping them out of the no-oxygen zone that makes imminent pullbacks inevitable.

I haven't been concerned yet about the failed breakthrough attempts by the S&P, as my own rule of thumb is that the first two or three attempts are almost always rebuffed. Part of the motivation for the recent rally has been anticipation of the next round of testimony by new Fed chief Janet Yellen, who is expected to reveal nothing new to the Senate Thursday, along with the breakthrough assurance that if things get really bad, the Fed might think about doing something.

If the S&P can't finish at a new high on Thursday and then confirm it, I would look for the potential pullback I wrote about last week to begin. It could be sudden, too, given the short-covering that's already taken place. If it does break through and the action carries on through Friday, I would begin fading both the IWM and the MDY that afternoon, and keep going until they broke. Beware the marginal new high.

The next issue is where we should be. Entering the new year, the theory had been that the tapering Fed was handing off to a stronger economy, thus somehow justifying both elevated valuations and the annual ritual of foreword earnings forecasts that are always inflated by 15%, then cut just before every quarterly earnings season so we can read about how companies beat estimates (e.g., according to FactSet, Q1-14 earnings are forecast to grow by only 0.1%, while the year is projected at 9.0%. It never ends).

The January pullback was touched off by a combination of weak economic releases and lack of Fed assurances that it would immediately hit the pause button. Eventually the weather stayed cold and snowy enough that it disqualified all disappointing economic data as no longer meaningful, traders decided that Yellen was the dove they hoped she was, and prices rebounded.

Corporate earnings for the fourth quarter were not a blowout, but did benefit from easy year-on-year comparisons and at about 8.5% year-on-year, were ahead of recent quarterly rates. Revenue growth remains weak, though, and retail sales excluding autos appear booked for another poor month. The news in housing has been weak but not all bad, at least going by the latest new home sales report and comments from renowned housing analyst Ivy Zellman's appearance on CNBC that sent housing stocks soaring.

One of the ironies of Ms. Zellman's appearance was that she was skeptical of the Census Bureau positive surprise data for January new home sales, saying her own research indicated that sales were flat (given that the former reported a huge spike in sales in the Northeast region, I'm inclined to agree - it could be another case of needing to average out the last two months). At the same time, she also said her data indicated that mortgage applications were up, not down as the Mortgage Banker's Association has it. She is predicting that the spring selling season will coincide with increased supply from the homebuilders and lead to a surge in new home sales.

It could happen. Wells Fargo recently loosened standards for FHA loans, so that's an additional help, and there will no doubt be some extra traffic and sales once the weather lifts (though it shouldn't matter much on the west coast or in Florida). Zellman is the housing analyst I most respect, though I would caution that she has been overoptimistic at times in the past.

There are several currents in housing and not all of them are running in the same direction at the same time, so the picture is probably going to remain not entirely clear in the near term. The slowdown in permits and starts is undeniable and not simply weather-related, but that doesn't mean that homebuilder stocks won't do well this spring (full disclosure: I am long Standard Pacific (SPF)). Income growth is still anemic and isn't likely to change soon, but investors have made up a steady part of sales. As Zellman suggested, investor groups could be looking at new builds for more rental supply stock this spring, and it's one group (largely all-cash buyers) that doesn't have to worry about tight credit standards.

That said, the twelve-month growth rate in new home sales has now dipped below 15%, from about 22% a year ago. My own projections are that homebuilding will grow again this year, but the growth rate will fall to 10%-15%, with a bias towards the low end of the range. Double-digit growth rates should sound great, but we are still at depressed levels and it does mean less of a contribution to economic growth this year.

I don't see that there has been any real change from the "new normal" we've been in the last few years. Inventory gave us a bump above trend in the third quarter of 2013, weather is giving us a tug below trend in the first, along with some inventory payback. In combination with the taper, this is going to lead to trouble for equity prices, though when exactly that begins is still hard to say. This week's rally attempts were something of a mystery, with the talking heads earnestly discussing the strength of the retail investor, the trend, or sunspots in the mornings, then scratching their heads in the afternoons. The persistent selling above 1850 on the S&P is a warning. We're set up for at least a mild pullback that should begin sometime after Yellen's testimony, depending on how accommodating she does or doesn't sound.

The claims data hasn't been pointing to a strong jobs report next week, which should set the tone until the next Fed meeting, but I'm not going to guess what the Labor Department will come up with. We're very close to the first quarter top I've been writing about since early January, and it still looks to me like a top to sell. Perhaps the Fed will surprise us in three weeks' time, but Fed policy is the other event I don't try to guess. Whatever the FOMC may say or do, living off liquidity dreams has never lasted forever, and I don't think this time will be different.

Disclosure: I am long SPF. 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 may initiate a short position in IWM over the next 72 hours.