The Adjustment Period
A correction is finally upon us. Traders have been holding their breath for weeks and can finally exhale. Portfolio managers holding onto 10 to 20% in cash while the market rose are probably feeling itchy on the trigger to put that money to work, as performance anxiety sets in. A lot of weak hands bought the 30 point rise in the S&P 500 after it had already reached overbought territory weeks ago. Now that the technicals have reversed, sentiment has changed and a correction is at hand. How deep and for how long is not really a very big question, but it’s one we’re all asking at this point. The bigger question is whether stocks can rise without QE? To answer that fundamental question, let’s first talk about what has helped to take the S&P 500 to 1530 since last summer and then let’s talk about what has changed since yesterday.
Recall that the market began to rally last year based on the defense of the euro by the ECB in July. Mario Draghi began to talk tough and the market took note. In September, the ECB opened the Open Market Transmission facility (OMT) to support sovereign bonds and it has worked so far to keep yields down, but has yet to be tested. In addition, you had the Federal Reserve initiate QE 3.0. After the elections, the U.S. market began to correct as the Fiscal Cliff became the primary focus. On November 16th, the picture of four congressman and senators from each side of the aisle promising to get things done reinvigorated sentiment. The Fed in early December took another step towards full QE with the removal of short-term Treasury sales. Now, its long-term Treasury purchases could be categorized as outright QE - call it QE 3.5 if you will.
Two other macro items were served on the bullish platter in December which was the recovery story in China, with their stock index up nearly 15% on the wave of manufacturing improvement. The second item was political pressure from Japan’s Prime Minister to goose accommodation to target a 2% inflation rate. Finally, on December 31st we had a partial solution to the Fiscal Cliff presented and cash sitting on the sidelines for investors and companies was put back to work in January. Equity mutual funds showed net inflows and mergers and acquisitions that were postponed for the time being were set into motion.
This is all to say that investors were served a generous portion of macro calm in the last two months, which was the icing on the central bank accommodation cake. I believe we still have the icing. The macro picture has changed little over the last few days. We still have sequestration on March 1st that will generate some chest beating on both sides of the aisle in Congress over the next week, but I think we’ll muddle through it as we always have. However, as it stands right now, it seems that the Republicans are confidently holding taxes unchanged and will not budge to escape cuts to spending.
So what has happened to change investor sentiment as of late? I think it’s a portion of the market being technically overextended, a portion adjusting to a less accommodative Fed, and finally a portion of debate over growth. Summing up some of the concerns over the last few days, they are:
- The Wal-Mart Bloomberg article about executives sweating sales in February
- Toll Brother’s earnings
- Financial interest margin concerns during earnings season
- Caterpillar’s orders
- Concerns over property tightening measures in China since Monday
- Europe’s PMIs were disappointing today and gave back January’s gains
- Philadelphia Fed Survey down to -12.5 from -5.8 in February
- Finally, the Fed’s hawks are swooping down on the doves to ease off QE
Yesterday’s FOMC minutes for the January meeting were the final catalyst that punched the S&P 500 through two technical levels of support: the first at 1523 and the second at 1514. The next support level is 1495. In an email I sent my colleagues last Friday I talked about the topping process for a pullback which entailed the following:
- Market becomes overbought on huge momentum (1/22-1/29)
- Market consolidates from said momentum (1/24 – 2/7)
- Market direction resumes to new highs on less momentum (2/7-2/19)
- Momentum and breadth (participation) diverges as fewer companies participate in market direction while some stocks have already begun to place a top (1/29-2/19)
- Breadth rolls over, technical supports get taken out, and the VIX climbs (2/20-…)
A correction is a healthy process. It allows for momentum to reset and excess bullishness to release from the valve. It allows for responsible stock purchases on pullbacks instead of chasing momentum. It allows for breakouts at key levels to be retested, solidifying new bullish trends. A correction is here, but I don’t believe it is the setup for the next 10% correction nor is it the beginning of the next bear market.
The trend in stocks has been doubted since last year’s summer correction. Many still doubt Europe’s bond market is on stronger footing and that China has in fact reaccelerated growth after many quarters of deceleration. This is a positive in the sense that the stock market continues to climb a wall of worry, allowing time for more believers and buyers to enter the market. We can see that easily in the flow of funds data from ICI which clearly shows that money has been exiting domestic stocks and flowing into bond funds for some time now, at least until January.
We are entering an adjustment period that is critical to this bull market. Can the U.S. economy, and the economies of the world, grow on their own merits and not by the liquidity of money printing by the central banks of the world? This is the largest macro question the market has had to face since the sovereign bond crisis began in Europe three years ago. 2013 will be the year this question finally gets answered. Some of the positive signs have been the stabilization in the sovereign bond market for Europe in 2012 with the onset of Long-term Refinancing Operations (LTRO, Dec 2011) and then Open Market Transmission (OMT, Sep 2012). Economically speaking, PMIs for the U.S., Europe, and China have been rocky lately, but they’ve turned up from their lows last quarter. This is about the time that they turned down last year between March and April. It will be critical over the next few months that these numbers continue to improve, even if the Federal Reserve drains the punchbowl of QE. So far, the world economies have not shown they are capable of sustaining growth without Central Bank help, so it will be important to watch as we go through this adjustment period.
Lately, accommodation in Europe has already begun scaling back. LTRO repayments continue to come in with an expected €100-125B of LTRO2 repayment this Friday. Now, we’ve had two FOMC minutes that have revitalized the debate over when to scale back QE. While the Fed’s zero interest rate policy (ZIRP) has a clear target of 6.5% unemployment or 2.5% inflation, QE’s goals have not been as well advertised as ZIRP has. The ambiguity of it helps to keep inflationary expectations tethered as evidenced by the cap on gold since September.
Investors bid up gold from $1550 to $1800 on expectations of monetary easing from the Fed last year, and they got it. But while the Fed has been purchasing $40 billion in mortgage-backed securities and now $45 billion in Treasuries, minus sterilization, gold has steadily dropped. I believe there are many reasons for it technically, given performance anxiety last fall, but one of the other reasons is that QE is not date-based as it was before. The Fed policy voters are debating the need for varying QE from meeting to meeting while others debated whether a removal here would be too premature. QE as a policy tool has not provided the escape velocity that economies need and finally, the central bankers are debating its efficacy. So here I think the ambiguity continues to frustrate commodity and currency traders, but eventually we will enter an adjustment period when gold will go up based on inflation expectations rather than on Fed policy alone and/or the resurgence of growth in the global economy based on merit – like it did in 2007.
Looking at the Conference Board’s Leading Indicators for January, released today, it clearly shows that we don’t have the escape velocity that economists want to see for growth. So there’s plenty of ammunition still available for the doves to continue to stay accommodative. The U.S. economy continues to just muddle along.
Eventually, the Fed will remove QE and we will enter an adjustment period as investors begin to discount the end of a global easing cycle. That period may have already begun, but ZIRP will remain for some time to keep the credit spigots open. That last Flow of Funds release from the Fed showed that credit continues to expand in the U.S., but it was 2.5% less than in the second quarter. Within the data, we saw that most of the total deceleration in debt growth came from a decrease in debt from households. State and local government growth was flat and federal debt decelerated from a 10.9% annual growth rate to a 6.2% annual growth rate. We’ll get the next release on March 7th for the fourth quarter to gauge if debt is decelerating still. For the economic engine to continue running, we need to see that credit is being demanded and supplied. With the U.S. considering various austerity measures in the form of cuts to government spending, it might be up to businesses and households to keep the music going, and that will be difficult to get the economists the escape velocity they want to see. Now that investors are over the euphoria caused by the solution to the fiscal cliff part 1, growth is the question on everyone’s mind and that’s going to take some adjusting to in the markets, right about the time we are served the second part of the fiscal cliff.
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