Over the last two weeks, the market has churned sideways as hedge funds leave the momentum trade in high beta and small-cap names to sit on the sidelines or trade into large-cap and non-cyclicals. This market is no stranger to the risk on versus risk off trade, and it appears risk off is in full swing. On top of the churning, the stronger economic numbers (ISM and now GDP) and the concern that tomorrow’s jobs report might wind up surpassing the Street’s expectations are causing investor’s tapering expectations to accelerate.
Over the past two weeks, investors and momentum investors are trimming extended positions in small-cap, cyclical, and high-beta companies and are now buying large-cap and non-cyclical companies. The outperformance of the Russell 2000 broke down last week when it began to underperform the S&P 500. While the Russell’s long-term trend has been violated, it triggered a short-term sell signal last week and that was confirmed by today’s break below 1087. The next support level is the uptrend near 1060 and the October low at 1037.
Some of the other areas under selling pressure are the oil and exploration producers (especially in fracturing plays), biotech, internet stocks, and Chinese stocks. These areas were extended two weeks ago and have pulled back. If they pull back any more, they run the risk of reversing their long-term trends.
Why now?
Hedge Funds need to earn their keep. They need to justify their 2% management fees and their 20% cut of the profits. They’ve had problems in the past few years showing their justification for such high payouts with abysmal returns. There’s only two more months to the calendar year, so you can bet they want to keep their performance. That’s why we have rotation, High Frequency Rotation (HFR), as Jim Puplava says.
So rotation is happening, yet again. The other trading catalyst that has just begun to form again is the idea of an accelerated timetable to the Fed’s taper and the process the market will go through to discount it. It appears that discount started today, but actually, it began last week with the strong ISMs, jobless claims, and the Fed’s neutral decision. The Fed’s neutral policy decision was also cemented by last Friday with comments from James Bullard, the St. Louis Fed President. He said that if labor markets continue to improve, the central bank will be able to cut back on its bond-buying stimulus campaign. He reiterated that the decision to cut purchases is data-dependent; and thus far, economists were too bearish in their estimates on U.S. strength during the government shut-down and debt-limit circus debate.
But here’s where I think investors have things wrong. There were two other very powerful numbers released last week called the CPI and the PPI.
Stay Softy America
The headline CPI rose 0.2% which puts the annual rate near 1.2%, the slowest since April. That’s well below the Fed’s 2% target. Recall that the Fed removed the “transitory pressures” on inflation to “persistently low” inflation. This gives the Fed plenty of room to continue their purchase program until they finally get the results in the job market they're seeking. Low interest rates continue to help in auto purchases and home purchases. That’s noticeable in the huge Chicago PMI last week where the region is heavy in autos manufacturing in comparison to the rest of the US.
Producers Prices (PPI) was down 0.1% month over month with the annual inflation rate at 0.3% year over year. That’s a pretty big decrease from 1.4% in August. That gives room for the Fed. In the same speech on Friday, Bullard said he would like to see the Fed’s 2% target for inflation reached before scaling back asset purchases.
The European Central Bank (ECB) surprised the market with a rate cut today that sent the dollar rallying and commodity prices lower. We were expecting for the ECB to change its tone this meeting to prepare the market for a cut in December, but it looks like they took that a step further. Either way, if the ECB starts a new easing policy and the Fed does not, we’re likely to see higher dollar and lower commodity prices, which should keep inflation low.
In Summary
The market is selling off because momentum investors are taking profits and reinvesting in beaten up large-cap and non-cyclicals. It’s really that simple. An accelerated time table for the Fed Taper might be the reason the media has stamped over the correction, but reasons a momentum guy/gal hits the sell button are typically simpler than that. The market was overextended, overbought, etc. and profits needed to be protected. It may be that good economic news gets bad press and more taper-talk over the next couple of months, but in the end, this market will always steer back towards fundamentals and they are strong in the US with low interest rates, low inflation, robotics, manufacturing renaissance, and the fracturing boom where a majority of the country’s economic wealth is being built. We remain bullish long-term on the market and only see debt-limit and taper discounting to be intermediate-term issues that the market will eventually digest.
