Market Tremors Signal That Something Wicked This Way Comes

by: Eric Parnell, CFA

"By the pricking of my thumbs, something wicked this way comes"

-Shakespeare, Macbeth

The tremors that rumbled through investment markets this past week may be signaling that something far more wicked may soon be on its way.

"Fair is foul and foul is fair, hover through the fog and filthy air"

-Shakespeare, Macbeth

Just as it has all year, a look at the U.S. stock market would suggest that all must be well. Although stocks as measured by the S&P 500 Index (NYSEARCA:SPY) actually declined by -0.50% over the past week, this is a very modest pullback considering the market is up +11% year to date. Moreover, the stock market has risen in 37 of the first 57 trading days of the year, or 65% of the time, which is an extreme deviation from the historical average of just 52%. One would reasonably expect such a sanguine stock market rise to occur only under the best of circumstances. Instead, it is happening in an environment marked by persistent instabilities and a bubbling brew of new stresses threatening the market.


"So from that spring whence comfort seem'd to come, discomfort swells"

-Shakespeare, Macbeth

As many cite the rising stock market as reason for optimism about the outlook, unfortunately this is a story we have already seen play out before during the ongoing financial crisis. In both 2010 and 2011, the stock market opened the year with gains through the spring. And in both instances, these gains were accompanied by fresh optimism that a true economic recovery was underway and that the crisis was finally behind us. But discomfort soon swelled, and the comfort of spring was replaced by market turmoil over renewed concerns of crisis in the subsequent months.

So might we expect the same discomfort to upend the stock market in 2012? Maybe. Maybe not. But a variety of signals have recently surfaced suggesting that something wicked may be coming. The following outlines a few of the issues threatening the market.

Gasoline Pushing to Reach New Highs

The Fed can declare all that it wants that inflationary pressures are fully contained. But all the average American has to do is drive by their local gas station on any given day to see otherwise. Despite an overall decline in gasoline demand, the price has soared along with stocks since the advent of the latest monetary stimulus program and is now pressing to reach new all time highs.

As long as gasoline prices continue to rise, the hands of the Fed to enact further monetary stimulus to try and support the economy and financial markets will become increasingly tied. This is likely to be particularly true given a presidential election season about to get in full swing in the coming months, as the Fed will likely not want to be perceived as trying to impact the outcome one way or another. In the past, the stock market has plunged once monetary policy stimulus has been removed from the system. And the Fed may not have the luxury to freely step in with additional policy support the way it has in the past.

Volatility Now At Complacent Extremes

The Chicago Board Options Exchange Market Volatility Index, or VIX, is a measure of implied stock market volatility based on the price paid for options based on the S&P 500 Index. When the price of the VIX rises, it indicates increased investor fear. Conversely, when it declines, it suggests greater investor complacency.

Over the past several days, the VIX has fallen to lows last seen only twice before in the aftermath of the financial crisis. The first instance occurred in April 2010. The second instance occurred in early May 2011. In both cases, the VIX arriving at these same low levels signaled the stock market peak before the subsequent decline.

Bulls Are All Getting On Board

The talk about the market had already been bubbly. But in the past few weeks, we have seen a variety of major financial institutions declare that now is the time to buy stocks. This includes Goldman Sachs, whose analyst this week declared that prospects for stocks are as good as they have been in a generation. Given the nature of the move we have seen in the stock market both year-to-date and since early October 2011, the timing of these bullish stock market calls might be considered dubious to say the least. And from a contrarian perspective, they may be signaling a potential turn in the market may be coming sooner rather than later.

Agriculture Prices Are Not Confirming The Rally

Over the last several years, agriculture prices have moved in advance of the stock market by three months on average. But in the current rally that began last October, agriculture prices have not participated at all. And the divergence is only getting wider as time passes. This suggests that stocks may be floating ever higher on forces that are not sustainable.

Utilities Preferreds Signaling Potential Liquidation Trouble

Utilities exchange traded debt is normally a very consistent and steady group. Price variation is typically minimal as prices have incrementally risen over the last few years. But on three past occasions since the stock market bottom in March 2009, these securities have experienced brief shocks of sharp price volatility. And two of those instances occurred just as the stock market was entering into an extreme price decline. Just this past week, the fourth such shock was witnessed in this area of the market. Perhaps it is just an isolated event just as it was back in December 2010. But the trading activity among selected Utilities exchange traded debt during the past week resembled forced liquidation in many ways.

The Crisis In Europe Continues To Deteriorate

Policy makers around the world conducted a great deal of heavy lifting so that a Greek default could be carried out in an orderly fashion. But Greece is already showing indications that it will need further financial support sooner rather than later. At the same time, investor focus has turned to other at risk sovereigns, as bond yields continue to drift wider in Portugal and recently began shifting higher in Spain as well. It is only a matter of time at this point before the situation in Europe returns to the headlines.

The above are just a few of the many ingredients in the witches' brew that could suddenly bring a wicked outcome to investment markets at any moment and time. Growing signs of an economic slowdown in Asia and the potential for military action by Israel against Iran are among the other important issues that also merit watching in the days and weeks ahead.

Given the mounting threats to the stock market outlook, I have been in the process of recalibrating hedged exposures in recent weeks. Allocations to the stock market remain defensive but are gradually being pared down as we move toward the end of the latest Fed stimulus program in June. Representative positions include those that have shown resistance to major stock market declines such as McDonald's (NYSE:MCD) as well as high quality names that have participated little in the rally over the last several months including General Mills (NYSE:GIS) and Tootsie Roll (NYSE:TR). Beyond stocks, the recently higher than normal correlation between stocks and precious metals has resulted in a recategorization of stock allocations to gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) to provide stock like exposure with the potential for greater upside from current levels going forward.

The more attractive opportunities have presented themselves in fixed income in recent days. The recent sharp sell off in Long-Term U.S. Treasuries (NYSEARCA:TLT) and the Japanese yen (NYSEARCA:FXY) has provided the opportunity to establish positions that represent a direct hedge to the stock market at lower prices. Both national municipal bonds (NYSEARCA:MUB) for taxable accounts and Build America Bonds (NYSEARCA:BAB) for qualified accounts also sold off recently and now represent attractive opportunities from both a capital gains and income perspective at recently discounted prices.

Perhaps it will be different this year versus the past two. And perhaps the stock market will remain resilient against all of the pressures boiling under the surface. But if nothing else, remain cautious of the stock market that appears the innocent flower, as the serpent may now be lurking closely underneath.

Disclosure: I am long BAB, FXY, GIS, GLD, MCD, MUB, SLV, TLT, TR.

This post is for information purposes only. There are risks involved with investing including loss of principal. Gerring Wealth Management (GWM) makes no explicit or implicit guarantee with respect to performance or the outcome of any investment or projections made by GWM. There is no guarantee that the goals of the strategies discussed by GWM will be met.