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The Big Risk Of A Negative Feedback Loop

|Includes: CBRE, HD, iShares U.S. Real Estate ETF (IYR), LEN

[I wrote this over the weekend. SA passed on the article Monday afternoon: UPDATE - I sold out of the last of my international stock exposure near the top of the recovery rally today and cut U.S. Growth stock exposure by 50% nearly nailing today's top. I feel very lucky and grateful. I don't like to see small losses grow but more importantly I feel the likelihood we retest today's lows is VERY HIGH.]

  • U.S. Real Estate & IPO Market Key To Stock Market Near-term.
  • U.S Consumer Is In A Foul Mood.
  • Negative Feedback Loop Could Produce Viscous Market.

Last week was the worst week for stocks in years, with major indices closing near lows on a spike in volume on Friday. In terms of the growth strategy I manage, I'll be looking to take additional defensive action in client accounts if conditions continue to deteriorate. I started reducing exposure to stocks earlier this summer and my growth strategy is now underweight stocks by approximately one-third.

The nature of this particular correction has increased the odds we are going to see a steeper decline. There are a few strings still holding markets together but it would not take much for them to break. The biggest risk for the U.S. is the impact a potential negative feedback loop could create. The opposite of the wealth effect, where consumers are supposed to increase their consumption based on higher 401k balances, a negative feedback loop is where bad news causes consumers to pull-back their spending which causes economic conditions to deteriorate making things worse. The possibility of this type of scenario developing is very high given the currently cynical nature of consumers. Tired of being lied to and told increasingly what they must do and cannot do, the U.S. consumer is in a foul mood.

Let's start with what is working, U.S. real estate. As I have mentioned to clients and in public commentary recently, the recovery in U.S. real estate is one of the few bright spots in the U.S. economy. While the current market sell-off put a dent in some of the investments I have been following in this industry, Home Depot (NYSE:HD), C B R E Group (CBG), and more broadly the iShares Real Estate ETF (NYSEARCA:IYR) are trying to hold on. HD is the strongest of the group and remains just below a recent all-time high breakout earlier this month. CBG is also trading near an all-time high it hit earlier this year but has move to the bottom of a trading range. A move lower by this commercial real estate leader would be a bearish development for this market segment. More broadly, IYR has yet to reach its all-time high back in 2007. It has a small loss year-to-day and is trading in the lower half of a base it started in February. Home builders have been doing well in 2015 and Lennar Corp (NYSE:LEN) remains near the breakout it established earlier this month. As long as real estate related stocks hold at current levels there is a reasonable chance markets will settle down for a more shallow correction. Additional weakness in real estate related investments could spell trouble for the broader economy and stock market.

The other factor I am watching closely based on the positive impact it is having on the market right now is good-old innovation, despite the continuous attack on American exceptionalism. The current IPO market, while not as strong as other cycles, has witnessed many new companies achieve an IPO from technology, healthcare, consumer and many other industries. The First Trust IPOX 100 EFT (NYSEARCA:FPX) fell below its 200 day moving average on Friday so ideally this fund can trade back above that level on the way to new all-time highs, something it achieved earlier this year on a history going back to 2006.

In terms of economic growth it remains a mixed picture. In the U.S. New Jobless Claims continue to come in a bit higher, perhaps marking a bottom. Housing activity continues to ramp up with existing-home sales up for the 3rd consecutive month. Internationally, China's manufacturing activity hit a 6-year low and Greece's Prime Minster Alexis Tsipras resigned complicating their ongoing bailout program.

Given the swift and steep selloff in stocks the likelihood of a Fed rate hike in September has fallen. Expect a full slate of appearances over the coming days designed to bring stability to the markets. The Fed could find itself in a real bind if markets don't stabilize soon.

With a current forward P/E of 16.5 for the S&P 500, stocks appear only slightly overpriced based on historical measures. If stocks correct based on a mediocre economy not justifying an above mean forward P/E, a 15% correction would take the market down to a forward P/E of 14. After last week we are about half there. This assumes nothing changes with EPS estimates currently at $127.40 according to FactSet. Any rumblings from corporate America about weaker forward guidance would be very difficult for the market to handle at this juncture.

When you add it all up we find the U.S. stock market and economy in a very precarious position, one were many remain unemployed or under employed. Despite the stats, participation rates are way down and wages have stagnated. Additional market declines could cause consumers to tighten the purse strings which would crimp corporate sales and earnings; that is when things could get much worse.

While some suggest the sell-off of 2008 was a once in a lifetime event, investors concerned it could happen again should be prepared to take action now. I successfully navigated the 2008 market with very small declines and have composite performance data to back it up. I have already generated a good portion of cash in my growth strategy and I will be looking to move more defensively depending on how things unfold going forward. If this sounds interesting to you drop me a line. Better days should return but in the meantime it looks like policy makers need to do a much better job of addressing secular changes in our economy if they want to avoid asset bubbles and create a more sustainable recovery.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in IYR over the next 72 hours.

Additional disclosure: No investment recommendations have been made in this article. Investing involves risk including the loss of capital. Conduct your own research before making any investment decision.