The five fundamental drivers that could spark a stock market correction are:
- Spain may choose to delay a formal request for aid.
- An increasing demand for safe-haven assets.
- Global growth is slowing.
- Earnings may disappoint.
- The 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:
“I think 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 get.”
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 sessions.
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.
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:
“Fiscal 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 be cautious.
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.
Source: Ciovacco Capital
