Cyclical Tailwinds vs. Secular Headwinds

by: Greg Feirman

In the absence of additional flaring of the sovereign debt dilemma, the momentum that existed in the U.S. and global economy prior to the recent flaring may be sufficient to push investors in the second half of 2010 back into a risk-on mindset. The next month or so is crucial in this respect.

It remains to be seen whether the cyclical tailwind or the secular headwind will dictate the course of economies and markets in the second half of this year.

- Tony Crescenzi, Pimco, quoted in Doug Kass “Cyclical Tailwinds vs. Secular Headwinds”, TheStreet.com, June 2

When you come to a fork in the road, take it, Yogi Berra famously said. It feels to me like financial markets have reached a fork in the road that will be resolved in the next few months.
Let’s briefly review recent history. From Tuesday March 10, 2009 through Friday April 23, 2010, the S&P surged from a closing low of 676 to a closing high of 1217 - an 80% move. From Monday April 26, 2010 through Wednesday May 26, 2010, the S&P had a nasty 12% correction from the closing high of 1217 to a closing low of 1068.
It is important, however, to realize that 1% down from a higher level is more than 1% up from a lower level. For instance, while the rally appears to be almost 7 times larger than the correction on a percentage basis, it is only 3.6 times bigger than it is on a points basis (541 versus 149).
The market is now trading in a tight range defined by the year's lows around 1050 and its 200 DMA around 1100. Think of these numbers as rubber bands that can stretch a bit but will break if stretched too far. We have traded within that range for the last 11 trading days.
Accompanying this market action is a split in market outlook. Most view it as a standard correction within a bull market. Representative of this perspective is Barron’s Streetwise columnist Michael Santoli who wrote last Saturday: “Maybe, no matter the monumental macro challenges that got credit for the drop, this has been a fairly typical correction just over a year into a market uptrend” (“Did That Correction Feel Typical?”, Michael Santoli, Streetwise, Barron’s, May 29).
Of the same mind is veteran money manager Steve Leuthold who wrote to clients two weeks ago: “Do not panic. I think this is a huge buying opportunity both for traders and long term investors” (quoted in “Investor Anxiety Makes A Comeback”, E.S. Browning, The Wall Street Journal, May 24, C1).
Others, however, view the market action more ominously. A few days before Leuthold’s note, Dow Theory Letters’s Richard Russell wrote to subscribers: “If I read the stock market correctly, it’s telling me that there is a surprise ahead. And that surprise will be a reversal to the downside for the economy, plus a collection of other troubles” (quoted in “Richard Russell: ‘Sell Anything’”, The Pragmatic Capitalist, May 18).
Tony Crescenzi captured the larger forces at work nicely in pitting the cyclical tailwind from the economic recovery against the secular headwind from the still massive bad debt overhang as exemplified in the recent sovereign debt crisis.
Turning to history using a similar framework, Lawrence McMillan, President of McMillan Analysis Corporation, persuasively compared the current market to the markets of 1937-1945 and 1973-1982 (“History Paints A Bleak Picture”, Larry McMillan, MarketWatch, June 1). During each of those periods, crushing bear markets were followed by spectacular “liquidity rallies” driven by government money pumping. However, each of those liquidity rallies fizzled out after a year or two to be followed by grinding, multi-year, range bound bear markets. His hypothesis: “This general description fits the 1907-1917, 1937-1945, and 1973-1982 markets. I contend that, when history is finally written, it will also characterize the 2007-2015(?) market as well.”
I think everybody knows where I stand on this by now. From the start, this bull market's days were inevitably numbered. The recent correction suggests to me that it is over. Alas, so did the late January-early February correction. The stock market cannot be predicted with scientific precision and to attempt to do so is hubris. Perhaps this bull has one last hoo-rah. Perhaps even an encore after that. But the fundamentals dictate that at some point financial markets will have to pay the price.
YTD Performance (through 5/28)
S&P: -2.30%
DJ Total: -0.82%
Top Gun: -0.36%