European stocks have taken a breather this week on the back of political unrest in Spain and Italy over the weekend. The market has had a nice month clear of tail risks. With the extended move in equity markets worldwide, investors are looking for excuses to take profits.
Summing up the issues here, Silvio Berlusconi vows to rid Italy of German-led austerity measures and promises to cancel a property tax in a clearly political maneuver to win votes as he said, “We need to get rough with Germany.” The bond markets didn’t like hearing this as equities fell and sovereign yields rose. In Spain, the Socialists demanded Prime Minister Mariano Rajoy resign over a corruption scandal regarding payments from a slush fund operated by the former treasurer. That too caused Spanish bond yields to rise.
Central Bank-led Background
In looking at a brief recount of how we got here, let’s look at what Central Banks have been doing worldwide over the past half year.
Many investors have flocked overseas with the rise in the euro that began in July. Mario Draghi, President of the European Central Bank (ECB), came to the euro’s aid not because imports were too expensive, but because there was an underlying risk that investors were pricing in a return of domestic currencies and the “end of the euro.” Since then, European stocks have come back and have outperformed U.S. stocks. The ECB later announced the Open Market Transmission in September that basically added a put to troubled sovereign bond markets that officially requested help. Dating back to December of 2011 with Long-term Refinincing Operations, the ECB has continually supported the sovereign bond market to remove tail-event risk from the market, and it has worked for now.
U.S. stocks responded to the European-led rally with one of their own. To top things off, our own Federal Reserve announced QE3 in September with mortgage-backed security purchases and removed the sterilization component to operation twist in December. Maybe call that QE3.5. Despite the mini-crisis with the Fiscal Cliff, U.S. equities are extended now and are dealing with an overbought condition that has been ongoing. Instead of correcting with price, we have been correcting with time in a sideways trading range between 1495 and 1515. The S&P 500 has stalled recently here, possibly ever since the FOMC minutes in January which began to discuss the appropriate end to QE3.
China has been stimulating its economy through the People’s Bank of China which began to undertake a package of measures to support growth last summer. Manufacturing began to turn up again in the 4th quarter last year and the Shanghai has responded with a phenomenal run from 1950 to currently 2418. There was an article on Monday that China bank regulators limited lending from the Bank of China and the Industrial & Commercial Bank of China, a move that could signal rising inflation concerns; but the fact of the matter is that loans are up 23 billion yuan from the big four banks during January of 2012 over a year ago. Yes the PBOC has told banks they need to curtail loans, but only because the banks are over exceeding their quotas on strong demand.
Japan has been in the news a lot over the past two months as the new Prime Minister, Shinzo Abe, has asked for the bank to begin to aggressively inflate with an inflation target of 2%. Recently, the BOJ promised to raise its inflation target to 2% with an open-ended commitment to buying assets to begin next year; however, this doesn’t seem responsive enough and it was said this week that the BOJ governor Masaaki Shirakawa will step down March 19, three weeks before his 5-year tenure ends. Abe’s political pressure and the news of Shirakawa stepping down have bid up stocks and cause the yen to sell off over the last month and recent week. Japanese equities are overbought.
So What’s Your Beef?
Now that we’ve discussed the actions of central banks from the U.S., Europe, Japan, and China that have led to the current rally, let’s talk about perspective. First of all, the accommodative measures by these big four central banks are still in effect. Secondly, while the equity markets have responded quickly to discount economic progress, we are just now seeing signs of economic recovery. Thirdly, interest rates have only just begun to creep up in response to that economic recovery. And finally, retail investors in mutual funds have only just now begun to accept the stock market rally from 2009 with a bullish inflection in inflows into equity funds in January. We’ve now had four straight weeks of net increases into domestic and foreign equity mutual funds as of January 30th.
That’s all to say that the drivers that have led to the rally in stocks the world around, are still here and will likely be here a while longer. That said, as I mentioned two weeks ago, the equity market has moved to far and too fast, discounting monetary accommodation and economic recovery. Long-term, I have plenty of reasons to stay bullish, but short-term I think a correction is due in foreign equities and the U.S. stock market: either a price correction or a correction in time (sideways).
Looking at the indexes from the Shanghai, Nikkei, Euro Stoxx 50, and the S&P 500, it’s clear that equities are extended and due for a correction. That appears to already be underway in Europe while the Nikkei and the Shanghai have only just recently reached overbought levels themselves. I don’t believe this will be a long-term top that may lead to the beginning of a bear market. I’m simply looking for a retracement of the recent advance and an opportunity to buy stocks in areas that are only just now bullishly inflecting like in energy and small to mid-cap technology. On a scale of 1-10 to numerically value the importance of these two issues, as Stan Weinstein would say, the long-term bull is a 10, and the setup for a short-term correction is a 1.
Charting the World Indices
Now that I’ve setup my short-term and long-term views again, because I want to be incredibly transparent here, let’s look at the charts. I’ve been discussing the S&P 500 for the past two weeks by looking at breadth, sentiment, and price. I’ve also reviewed sector rotation to determine where we are in the business cycle. Now it’s time to review the foreign equity markets that have all had decent runs as of late because markets are interrelated to one another. When Europe equities suffer, there’s a higher correlation U.S. and other foreign equities suffer. When China began its recent ascent, it highly influenced the outperformance of materials, industrials, and energy stocks since December. So let’s review.
I started off discussing what’s going on in Europe this week because they were the main reason stocks took a shot across the bow on Monday with 2357 declining issues on the NYSE. While the U.S. market rebounded nicely on Tuesday, the Dow Jones Euro Stoxx 50 failed to recover from the selloff. The index broke out above 2600 in December. The recent correction has served to retest that breakout, which is a good thing. We’re also sitting at trend support. If these two lines of support break, look for a more meaningful correction in February. If we rally, I expect higher highs and the trend to continue. Watch this support level closely.
Japanese equities have been bid up in advance of the BOJ meeting in January and they’re responding positively to news of the governor’s step down in March as a sign of more political pressure to reflate. Despite the long-term bullish implications, the run over the past two months is extended and due for a correction. Elliott Wave is a technical analysis counting tool that attempts to predict when an advance or decline might end. It appears as though we have traced out 5-legs of an advance. Momentum indicators are beginning to diverge with price which serves to warn of an impending correction. 11,408 was an area of resistance in 2010 to the bear-market rally.
If the Nikkei Average decides to correct in price and not just time, there is ample support near 10,300, which would roughly serve as a 10% bull market correction. As I mentioned earlier, this is the 1 and the breakout in the Nikkei is the 10 to focus on. I expect the Nikkei will continue to perform well in the near future post any short-term pullback based on the BOJ’s intentions to reinflate. A correction from overbought conditions should be considered a buying opportunity.
Like the Japanese Nikkei index, the Shanghai Stock Exchange Composite index has had an incredible run from December of 2012, up nearly 24%. Momentum indicators are overbought. There are no divergences to speak of, which is good, but the index just brushed up against a major supply zone that has affected rallies in the past. I’m anticipating a correction here based on this resistance zone and because of the 24% rise in the Shanghai without any retracement over the past two months. A correction here of 10% would go a long way to establishing a secular long-term bottom in Chinese equities. Otherwise, a break above 2500 would serve to shatter the current supply zone. But eventually, nothing goes up forever and a correction here is a likely probability.
Concerning the U.S. S&P 500 stock index, we continue to work off the overbought condition I’ve talked about over the past two weeks in a sideways correction. Until the trading zone breaks, we won’t know if a price correction is in the cards or another 40-50 point move higher is due. Let price do the talking. Support is 1495 and resistance is 1515. If a price correction takes place, I’m only anticipating 3-5% from the highs, which sounds like a buying opportunity. I base this on the strong breadth, sentiment, and flow of funds in U.S. equities in addition to bullish inflections in mid to late-cycle sectors. Oh yeah, and money printing, lots of it.
Summary
In summary, the chance of a major stock market correction is minimal. I’m looking for a short pullback to buy some of the strong sectors in the U.S. market and overseas stocks. It’s a good idea to trim from extended positions only to put that money in bullishly inflecting stocks that are just now beginning the bottoming process. I see such areas as in energy equipment & services as well as in semiconductor stocks. Apple’s correction and huge weight in the technology sector has masked performance there. If Apple really does stand to rally here based on value investors and use of its cash, then all the more reason to be involved in technology stocks. I believe foreign stocks will continue to work. If you’ve missed the rally, look at a correction over the next month (whether time or price correction) as an opportunity to jump in before inflation creeps up and central bankers rethink their policy stance. Only then will I consider a more meaningful correction in the equity markets.
