I've been saying for a while now that I expect new highs before the next bear market begins. I was bullish throughout the January-February correction; a trade that took heat but turned out nicely.
However, I've become a bit more bearish as the rally has continued. I still think there's a reasonable chance we get to new highs on this move higher. But as a thought experiment, let's go through various things that could derail the rally before we hit new highs.
No discussion of market risk recently can go without mentioning the Fed. I'd like to again quote banking expert Kurt Dew's take on the situation:
Monetary policy was changed as expected in December. And if we examine the key statutory objectives of policy - unemployment and inflation - they have performed as expected also since then.
Why then, are the effects of the Fed's current policy debate so negative for the economy? Because the Fed's leadership is having a difficult time becoming unimportant. The Fed's policy ruminations are getting too much attention. Policymakers seem not to realize that their best option has become producing simple, easily interpreted decisions based on consensus, not a flood of disputed positions that will affect financial markets for the worse in the short run.
He argues that in the long run, it doesn't matter a whole lot whether the Fed hikes in March, April, or June. The long-term difference in economic performance will be small. What matters is that we don't know which month it will be.
The market not knowing what is going to happen does create real losses. Economic actors are hesitant to take action in situations with more uncertainty. As Dew notes:
Milton Friedman and his intellectual forebears were sometimes wrong on the details - like policy based on M1 - but their fundamental point remains unassailable. If we wait long enough, monetary policy has no direct effect on real growth; its sole effects are on uncertainty and the rate of inflation. Monetary policy matters for economic growth because in the short run it affects economic uncertainty. Uncertainty, in turn, temporarily reduces economic growth.
But if the combined effect of the remarks of the current herd of cats comprising the Federal Reserve Board and 12 Reserve Bank Presidents is considered, their ability to create uncertainty is nothing short of phenomenal.
As the next Fed decision approaches, there is a decent chance they'll consider raising rates. The global economic mood has brightened sharply over the past six weeks. US economic performance remains good enough to hike rates. I don't think they should. But if they held back from hiking previously on China concerns; well, those concerns have passed, and nothing has meaningfully softened stateside.
A Fed hike here would dramatically reverse the recent move lower in the dollar, put the brakes on the rally in oil and metals, and reverse the flow of money into struggling emerging markets. A Fed hike would almost certainly put a serious dent in the stock market rally.
Even the possibility of a hike could be enough to trigger pre-decision selling. And the general spectre of Fed hikes is likely to return to the table, even if they put it off for the time being. We've been in panic mode long enough for people to stop worrying about the Fed. But a state of Fed anxiety is about to return to the market.
Europe remains a question mark for the markets. The UK continues to approach its vote on the EU question. If the forces in favor of leaving gain strength, it would almost certainly trigger some selling in European equities.
In Germany, Angela Merkel's party took a huge hit on Sunday, losing several regional votes in dramatic fashion. The rise of a strident anti-immigrant party and the decline of Merkel's ruling party add some uncertainty to the outlook for economic policy in Europe's most important member state.
The turning point in the election - migrants - reminds us that the refugee situation remains a serious and ongoing concern rather than a passing affair. I'm no European expert, but even my cursory reading indicates there is a much deeper problem than we in the Americas are factoring into our models.
Both Spain and Portugal also face significant questions about their political direction. While there's nothing that appears likely to trigger immediate selling, the possibility of a negative news event from Europe rocking markets seems quite high.
China's Fragile Stability
China has made a concerted effort to prop up the Yuan. Its currency has headed back to multi-month highs after a persistent and concerted effort by speculators to weaken the currency.
As far as we can tell in the West, China's economic slowdown doesn't appear to have stopped (though admittedly data is of questionable veracity when it comes to China). There's no guarantee that the expensive effort to prop up the Yuan will continue to succeed.
Things could suddenly destabilize in China after this period of relative calm. Chinese stocks (NYSEARCA:ASHR) remain really weak compared to other emerging markets. We can't rule out another big drop.
Oil: Can It Break $40?
Oil's (NYSEARCA:USO) rally has been one of the strongest catalysts for the markets in recent days. Few people were expecting such a rapid move up from the 20s. Unlike other moves in oil, this one has met very little resistance along the way.
And, perhaps most surprisingly, it has come with hardly a catalyst. Aside from a weaker dollar, there's almost nothing that correlates to the rally. Geopolitical risk hasn't emerged in any meaningful way.
There are rumors that OPEC will cut production, but we've heard that story before. The US and Canadian producers continue to struggle with low prices, but there's little evidence that a major supply cliff is about to be hit. And $40 is a widely discussed level where more capex spend on new drilling supposedly becomes marginally profitable.
It's very unusual for grinding bear markets to end with "V" bottoms. It'd be rare for oil to rip straight up from the $20s well into the $40s without a major correction. Even if you think we've hit the low for oil in this cycle, a move back to at least the low $30s should be expected to test the new buyers' conviction.
Finally, one should note how the market really hasn't moved that far, given the move in oil. Oil and the market have traded with high correlation, but it takes a lot of up action in oil to move the S&P 500 (NYSEARCA:SPY) much. If I'd told you a month ago that oil would get all the way up to $38, you'd probably have bet the S&P 500 would be significantly higher now than it actually is.
Realistically, if the oil/market correlation persists, what oil price would we need to get a robust new high for the S&P? $45 oil? $50 oil? It's asking a lot.
Also, the low-quality embattled oil producers have already squeezed short sellers badly. Normally, that sort of move comes as the tail end of a sharp bear market rally. It's not the sort of steady relentless pushes northbound that tend to make up the bulk of bull market gains. If you think oil is in a new bull market, you want to see volatility fall. Huge intra-day moves aren't good for the long-term stability of the market.
Large Chunks Of The Market Aren't Participating
If you want new highs, you generally need most of the market to play along. If your portfolio isn't heavily in emerging markets, materials companies, or energy, you've probably lagged over the past month.
The rally has been fairly narrow, and large swaths of the market aren't going with it. Important risk-on sectors like biotech (NYSEARCA:XBI) continue to barely tread water. And the performance of the major US banks is less than impressive. It's a challenge for me to look at a chart of JPMorgan (NYSE:JPM) for example and say, man, I think the market is going straight to new highs from here.
Disclosure: I/we 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.