I should have known better than to write an article about the possibility of a correction in US stocks. I took a lot of abuse from the bulls this week as the US stock market shrugged off – again, for now – the weak economic data that just keeps coming. That light at the end of the tunnel the Fed has been seeing may turn out to be a train but for now, investors – if you can still call the people who trade global markets by that term – have decided that even if it is a locomotive it’s probably the central bank equivalent of the Hogwarts Express. Surely the world’s central bankers will be able to conjure some kind of magic to keep the train from stopping at the bear market platform.
Interestingly, though, I see no reason to alter my view that the US market is due for and likely to get – at least – a correction in the near future (defined as the next few months, not the next few hours). The action this week did nothing to change the technical picture. Momentum in US stock averages is still waning and on a relative basis long term momentum continues to favor bonds over stocks, specifically long duration Treasuries over the S&P 500. And despite a recent run to new all time highs, long term momentum in small cap stocks has also rolled over. In fact, momentum in small caps rolled over before the large caps and this recent move higher hasn’t been sufficient to change the picture. In my book that is a non-confirmation of the rally from a momentum perspective.
There’s an old saying on Wall Street that tops are a process and bottoms are an event. The topping process in 2007/8 took roughly nine months before any significant downside was realized. We’re almost six months into a sideways move though so I think we are getting close. I’ve said for a couple of years now that the US market, even if it continues to go up, is, at best, uninteresting from an investment perspective. On a trading basis, of course, it has been far from uninteresting as money has been churning from sector to sector, running one up and one down based seemingly on nothing more than the whims of the traders who control this market and their perception of what the Fed – or some other central bank – will or will not do. But the moves have been relatively small and if one takes the time to look, the S&P 500 is basically unchanged since late November.
I’ve been struck recently by how quickly things happen in markets today and how quickly people are to dismiss anything that doesn’t provide instant gratification. I think that is a function of the rapid flow of information (mostly noise) – and capital – in today’s world and an unhealthy belief in the power of central banks. Investors – and I use that term loosely – today aren’t interested much in any analysis that runs deeper than what might happen today or tomorrow and next week is considered long term. In a sense, everyone today is a momentum trader, looking for the next hot sector or market where they can – hopefully – scalp a bit of return while ignoring any fundamental information that might get in the way of them making a fast buck. Investing fundamentals such as diversification and risk control are ignored, quaint notions that might have applied back before the world’s central banks decided that cause and effect didn’t matter but surely not in today’s brave new world.
The impetus for last week’s roughly 2% rally in US stocks was, as I mentioned above, the continued flow of weak economic data. It was a fairly light week for data but again it reflected the bifurcation of the US economy that has been ongoing for months. The industrial/manufacturing side of the economy is experiencing a rapid slowdown while the service side remains fairly healthy. So the ISM non-manufacturing index posted a relatively healthy 56.5 while on the manufacturing side inventories rose and sales fell, a combination that has hiked the inventory/sales ratio to its highest level since the last recession. The weak data on the manufacturing side, coupled with last week’s weak employment report, convinced traders that the Fed’s rate hiking plans will continue to be pushed off. That’s good news for those who believe the only thing that matters is the rate at which they can discount far off future profits.
Another feature of today’s markets is that any data points that reinforce the accepted narrative are readily accepted at face value while those that conflict are dismissed. Examples would include the interpretation of the US economic data, the labeling of China’s stock rally as a bubble and the almost desperate attempts to justify high valuations for US – and European – stocks. The fact that the service side of the US economy remains healthy while the manufacturing side struggles is dismissed because, as everyone knows, the US economy is “service based”. But that ignores the fact that the service economy is certainly linked to the manufacturing side and, importantly, tends to lag developments in the manufacturing part of the economy. The ISM non-manufacturing composite index was over 50 until well after the start of the last recession while its manufacturing counterpart had already been in contraction for months. The employment data is also a lagging indicator and it is more than a bit disconcerting that the Fed is concentrating on it for guidance on future policy. I am not calling for a recession – the yield curve and credit spreads argue against that right now – but the US economy has definitely slowed and using lagging indicators to dismiss it is a good way to get blindsided.
The commentary on China over the last few weeks has also been a case of accepting the agreed upon narrative and ignoring the evidence before our eyes. That agreed upon narrative is that the Chinese economy is in deep trouble and the Bank of China is blowing a stock bubble to replace the deflating housing bubble. Everyone has been quick to jump on the rally in China’s stock market as a bubble, while ignoring the fact that the Chinese market is not, by many measures, all that expensive. In fact, compared to the US market, China as a whole is in the veritable bargain basement. Certainly, the Bloomberg article about high school dropouts making up a large fraction of new stock trading accounts in China is worrisome. And the valuation of the tech sector on the mainland is probably nuts. There is certainly a whiff of speculation in the mainland Chinese bourses. But if that is the hallmark of a bubble then US investors would be wise to spend some time looking in the closest mirror.
One final example is the current narrative on Europe where markets are discounting a recovery that has emerged only in the imaginations of those who believe that QE is a cure-all. As our Jeff Snider pointed out just this week the economic data in Germany – and Europe more generally – is perceived to be improving despite plenty of evidence to the contrary. Investors have seen what QE did for stocks in the US and especially Japan and assume that the same outcome is pre-ordained in Europe. The Japanese example probably applies more here since their QE was accompanied by an obvious currency devaluation. Those buying European stocks see QE + currency devaluation and rush to buy a currency hedged European stock ETF. The rally in Europe is a self fulfilling prophecy based on superficial analysis. There is a big difference – in my opinion – between Japan, where the need for reform has been acknowledged and is being implemented – albeit slower than most everyone would like – and Europe where the need for reform hasn’t even been acknowledged. European stocks – and German stocks specifically – are priced for a perfection that is far from reality.
We live in a world of fast money, fast markets and crowded trades. Language is the only fundamental that matters at this point with the world’s central banks leading the conversation. It is, for now, a tough environment for anyone who thinks too much – or takes the time to think at all. One can’t take the time to analyze anything because the worst sin in this market is missing the move. Fear of missing out has displaced prudence and discipline. I don’t know when that will end but I am certain that fundamentals – of investing and for markets and individual company stocks – do matter. Envy, greed and the pursuit of instant gratification are a toxic mix that have been the undoing of many an investor. Patience, prudence and discipline has been a winning recipe for generations. Choose carefully.
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