The five fundamental drivers that
could spark a stock market correction are:
may choose to delay a formal request for aid.
increasing demand for safe-haven assets.
growth is slowing.
approaching 'fiscal cliff'
Just as more money is coming off the
sidelines, stocks appear increasingly susceptible to a reversal. An
intermediate-term peak in global markets could come sometime in the next two
weeks. Positive developments in Spain could alleviate our concerns, but for
now the current path of risk assets appears to be one of a topping process.
Before we outline some concerns, it
may be helpful to know we used a similar analytical approach to warn of
slowing stock market momentum on May 7, just before the S&P 500
dropped another 97 points. On May 25 or four trading sessions before
the S&P 500 staged a massive 208 point rally, our models told us to be
open to a bullish reversal in risk assets. Paying attention with an open mind
can be profitable. Over the last few weeks, we have booked gains in oil
(DBO), oil stocks (OIH), Germany (EWG), tech stocks (XLK), small caps (IWM),
Spain (EWP), Italy (EWI), gold stocks (GDX), foreign stocks (EFA), Europe
(FEZ), and silver (SLV).
Spain Still Playing Games
Europe has been the major drag on
global growth and the financial markets for the last thirty months. While the
European Central Bank (ECB) announced a game-changing bond buying plan in
September, Spain must formally request aid before the ECB begins to print
money or assist in bringing down bond yields. From Reuters:
we're in a bit of political limbo where markets are just waiting for Spain to
ask for help, because ultimately if Spain doesn't ask, the verbal boost from
the ECB is going to fade away," said Jo Tomkins, an analyst at
consultancy 4Cast. "The longer Spain holds out, the more impatient
markets are going to get and the more frustrated markets are going to
The waiting game
is a typical gambit for the cautious Prime Minister of Spain, Mariano Rajoy, who is known for dragging out decisions as long as
he can, both to seek the best political timing and to tire out opponents.
Some analysts believe he may now be waiting until after October 21 regional
elections, including in his home state of Galicia and the Basque Country,
before taking a decision.
Defensive Assets Say "Pay Attention"
Just as mathematics helps us
understand the spirals in a seashell, financial markets tend to rise and fall
in parallel and symmetrical patterns, which is why something as simple as a trendline can provide valuable insight to investors. The
video below examines the current patterns in global stocks (VEU) and an easy
to understand risk-on/risk-off ratio (SPY/TLT). The results tell us stocks
may be vulnerable to a reversal sometime in the next fourteen trading
sessions, with the S&P 500 stalling between 1,487 and 1,500. You do not
need to understand technical analysis to see the current patterns in play and
what to look for in the coming weeks to gain bullish or bearish insight. We
do not need to forecast what will happen, but only pay attention to what is
happening. The video explains what we will be watching in the coming trading
Synchronized Economic Slowdown
Last week, the HSBC Flash China
manufacturing purchasing managers' index showed manufacturing in China shrank
for the 11th straight month in September, with the headline reading remaining
below the 50 mark between contraction and expansion. In Europe, the news was
not much better. Markit Economics said that the eurozone composite PMI, which includes data points on
both the manufacturing and services sectors, declined to 45.9 from 46.3 in
August, the lowest level since June 2009. Back in the United States, the
Federal Reserve expressed the following concerns in their September statement:
The Committee is
concerned that, without further policy accommodation, economic growth might
not be strong enough to generate sustained improvement in labor market
conditions. Furthermore, strains in global financial markets continue to pose
significant downside risks to the economic outlook.
First Quarterly Earnings Decline In 12 Quarters
While it is often lost in our
central-bank driven world, company earnings still matter. According to NASDAQ.com:
If we do get
negative earnings growth this quarter as currently expected, that will be the
first decline in quarterly earnings since the earnings recovery got underway
after the end of the Great Recession in 2009. The earnings weakness is quite
broad-based, with half of the 16 Zacks sectors
expected to have negative earnings growth.
Watch Out For The "Fiscal Cliff"
The vast majority of Americans have
heard of the approaching "fiscal cliff", but many may not know
exactly what the term means. According to About.com:
cliff" is the popular shorthand term used to describe the conundrum that
the U.S. government will face at the end of 2012. U.S. lawmakers have a
choice: they can either let current policy go into effect at the beginning of
2013 - which features a number of tax increases and spending cuts that are
expected to weigh heavily on growth and possibly drive the economy back into
a recession - or cancel some or all of the scheduled tax increases and
spending cuts, which would add to the deficit and increase the odds that the
United States could face a crisis similar to that which is occurring in
Europe. The oncoming fiscal cliff is a concern for investors since the highly
partisan nature of the current political environment could make a compromise
difficult to reach.
Defensive Bias, But An Open Mind
While we have remained bullish for
over three months, we have also constantly advocated maximum flexibility and
open-mindedness. The fundamental bullet points outlined above are not
particularly new to the markets. Our concern is weak fundamentals appear to
be aligning with deteriorating technicals, which
often results in unfavorable conditions from a risk-reward perspective.
Investors can make money with strong technicals and
questionable fundamentals (see last three months). However, a combination of
weak fundamentals and weak technicals make it difficult
to produce stock market profits.
With the Fed already committed to
flooding the financial system with freshly printed money, and the European
Central Bank on the verge of joining the party, the longer-term outlook, for
now, remains bullish. It is the short-to-intermediate-term that concerns us.
Even after QE2 was announced on November 3, 2010, stocks and commodities had
a considerable "give back" period (see below).
Over the same post-QE2 announcement
period, silver experienced a painful short-term decline. In the present day,
Silver, like Spanish bonds, could rocket higher if Spain formally requests
aid from the ECB. However, silver could also have a sharp correction if Spain
continues to drag its feet. We took an 18% profit last week in SLV. We still
like silver, but the short-term risk-reward is not nearly as favorable as our
entry point in August.
Spain, ECB Hold Key Short-Term
Why have the markets been bi-polar in
recent years? Unfortunately, financial assets have become overly dependent on
money printing from central banks. The bull run could resume in a forceful
fashion if Spain clears the way for the ECB to join the Fed's money printing
party. However, as outlined in the video above, the charts are telling us to
Should the charts stabilize in the
bulls' favor and if we can avoid another spike in Spanish yields, we are
happy to redeploy our cash. Notice the last sentence pairs "should"
and "if" with bullish conditions, which means unless something
changes a correction may take hold sooner than many believe. For now, we are
happy to keep some converted profits in cash.