Market Outlook: Prepare To Break 1100 As QE3 Hopes Fade

Includes: FXE, SPY, USO, UUP
by: The Independent Investor

These past couple weeks have been very difficult to trade. Obviously those who have shorted the market over the past week have gotten hit hard. Likewise, since the economic data has been decent but not great, it's unlikely longs have been willing to really hold many positions beyond a couple days during the market's recent move up. To me, the primary problem with trying to short equities or commodities during this recent rally has been that so many hedge funds and other individuals have been positioned so heavily against the market that small positive surprises in the economic data have caused the market to rally disproportionately to the quality of the news. Also, prior to the market's negative reaction to the recent ISM report, bad news had been spun positively as some of the regional manufacturing data coming from the Philly Fed and Empire Manufacturing Index has been so horrendous that this information temporarily raised the prospect of a significant new QE program.

The market's continual rallies on both good a bad news over the past couple weeks has likely scared off many shorts. If this scenario were to continue it would likely remain very difficult to short a market that has seemed for the past week to truly believe in the "Bernanke put". Luckily for traders, I think that this very difficult trading environment created by negative news being continually spun in a positive light is coming to an end now that the recent economic data has painted a more complete story of an economy growing at anemic levels, but still showing no signs of falling off a cliff.

I think the reason the market has moved higher over the past couple weeks has been primarily because so many people and institutions who were heavily short the market had very large profits, as they had likely in most cases initiated their positions when the market was significantly higher. Likewise, in the oil market, institutions and others also likely initiated short positions when these markets were at higher levels and covered their positions when commodities fell hard. Given how short most traders were positioned coming into this recent rally, I think its important to analyze the real quality of the recent move up. The recent rally has occurred on very low volume and has not had any sector providing any real leadership with some of the companies having the the worst fundamentals making the biggest moves higher. The fact that stocks are moving largely as an asset class is a strong indication that the short covering in these sectors has been a primary catalyst moving the market higher. The other reason the market moved higher, in my opinion, was because of the previously mentioned premise that bad economic news was not necessarily negative for stocks since the possibility of a more robust QE3 initiative was increasing with each seemingly worse economic data point.

The other problem longs now face since the recent economic data has generally remained poor but still come in ahead of expectations is that even if QE3 occurs the Fed is unlikely to be able to justify an action of the magnitude needed to really move the market. The reality is that we appear to not be entering a double dip recession or facing stagflation, but instead seem to be entering a phase of low growth and fairly moderate levels of inflation. The best economic data is not showing any real growth, but it's also not suggesting the economy is falling off a cliff. While the simple black and white narrative of the economy either recovering normally or reentering a new and prolonged recession is too simplistic, the current data flow seems to suggest we will remain in a low to flat growth environment for some time. If the economy were truly falling off a cliff, as some of the regional economic data temporarily suggested before we got the recent retail spending and ISM reports, obviously negative news could have continually been spun positive since QE3 and possible further government action of real significance would have been back on the table. Today the possibility of a serious new QE3 initiative seems much more remote given the recent above average economic data, despite no signs of a real recovery showing up in these reports.

Herein lies the new problem for the market to move higher, in my opinion. If the economy was truly recovering and we did just hit a soft patch because of Japan, seasonal factors, or whatever the latest explanation for the Spring slowdown is, than we could buy stocks on the premise of a good chance of a decent second half recovery. Unfortunately, despite the endlessly irrelevant claim by many that corporate earnings and balance sheets are likely to remain strong, these facts, in and of themselves, cannot move the market significantly higher. People buy stocks because they believe the economy will continue to expand or because they fear inflation will increase. If growth simply holding up means we continue to see flat to slightly negative corporate earnings, the market will likely lack a sustainable catalyst to move higher.

Also, if the economic growth is anemic, but there still are no strong signs of a renewed recession it's still likely Central Banks and Governments will have a difficult time justifying any aggressive actions. Low to flat economic growth likely means their will be little upside to corporate earnings over the next year. In that kind of an environment I think it's unlikely people will see much upside in most stocks. While equities may seem like the the only game in town with the 10 year at 2%, the 30 year at 3.5%, and other safe heaven assets offering average to below average returns, I think many people will look at the market differently after the recent sell-offs. If the dollar continues to hold its value against major currencies like the Yen and Euro, as is likely if no new stimulus from the Fed or Congress is proposed, that means holding cash and getting low to zero returns won't make people feel poorer. Second, the European debt problem will not likely be conclusively resolved anytime this year. A separate series of articles could be written on many of the issues facing Europe, but the fact remains that tremendous political and financial challenges remain for the EU, and these issues aren't likely to be conclusively resolved anytime soon.

If people aren't willing to pay up for stocks and we continually get negative news from Europe and mediocre to bad economic data, the market isn't going to sit around waiting for helicopter Ben to propose a massive new stimulus plan when the economic data doesn't even show contraction and the political winds have changed. Likewise, even if the tea party was not ideologically opposed to stimulus spending, the fact that we are now entering an election year should ratchet down expectations of any substantial congressional action to stimulate the economy over the next year. Earnings may hold up, but substantive earnings growth is unlikely in this kind of environment.

In essence, flat seems to be the new normal, and as hopes of QE or strong government action dissipate, people may simply be willing to accept less risk to ensure capital preservation in an environment where most costs are not rising. Stocks are really not that appealing of an asset class when economies are not growing and inflation remains muted. If growth and inflation expectations remain low for some time, bonds yielding 2% may still have strong appeal to many individuals wanting some return without the significant risks they may still feel equity investments present. In the meantime, with the market seemingly topping out and the latest QE hopes fading, it seems fairly safe to short the market on the premise that whatever moves upward we will see over the next couple months will likely be limited. while European debt fears and the increasing possibility of a flat growth environment create the kinds of fears that should continue to put significant downwards pressure on markets.

Disclosure: I am short USO.

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