Is A Stock Correction About To Catch Complacent Bulls By Surprise?

Wednesday’s News Was Good, But How Does Big Picture Look?

With some better than expected economic news to digest, the S&P 500 was up 5 points early in the pre-holiday session, which added to the bullish list of things to be thankful for. From Bloomberg:

U.S. stocks rose as an unexpected drop in jobless claims and better-than-forecast confidence data indicated the economic recovery continued. “It just continues to look pretty good and it would not surprise if we saw acceleration in growth as we go into 2014,” Mackintosh Pulsifer, who helps oversee $15 billion as vice chairman and chief investment officer at Fiduciary Trust Co. International, said in a phone interview. The reports continue “to support the notion that we’ve moved from recovery into expansion. With each data point that comes in there’s nothing that’s signaling the direction is changing,” he said.

Corrections Are Deflationary Events

There are two basic scenarios that drive the demand for stocks relative to bonds:

Scenario One: Stocks typically correct due to fundamental concerns about the economy or earnings. Economic weakness tends to be tied to weak consumer demand. It is difficult for inflation to take off when consumer demand is weak. When demand and the economy are soft, the odds of central banks raising interest rates are low. If inflation is low and the odds of central banks raising interest rates are low, bonds become attractive since “keeping up with inflation” is relatively easy.

Scenario Two: Conversely when the economy is strong and consumer demand is healthy, inflation pressures increase, and thus the odds of central banks raising rates increase. Under these conditions, it is difficult to keep up with inflation by investing in bonds. Stocks are a better inflation-protection option for investors.

Stocks vs. Bonds Tells Us A Lot

The table above can be summed up this way:

When investors are confident about the economy, they prefer stocks over bonds. When investors are concerned about the economy, they prefer bonds over stocks.

It is also important to understand how asset prices are set…via the aggregate economic outlook/demand of all investors around the globe. If the aggregate economic outlook is favorable, demand for stocks will be greater than the demand for bonds. If the aggregate economic outlook is unfavorable, demand for bonds will be greater than the demand for stocks.

Fed Likely To Keep Money Printers Busy

Fed policy has unquestionably helped boost asset prices. The latest news on the Fed front pointed to more market-friendly policies as the calendar creeps closer to 2014. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke and his colleagues are suffering through their own form of cognitive dissonance: revealing new concerns. “Slower growth in productivity might have become the norm,” the central bankers noted at their Oct. 29-30 meeting, according to the minutes released last week. That’s a switch from past comments by Bernanke that the deceleration probably was temporary and would end as the expansion continued. about the economy’s long-term prospects even as they forecast faster growth in 2014.

According To The Latest Global Investment Survey

Charts are a polling mechanism. The chart of stocks (SPY) vs. bonds (TLT) below provides the aggregate answer to “are you confident about the economy and stock market?” The ratio rises when demand for stocks is greater than the demand for bonds, signaling investors are confident about future economic outcomes. Why should we care about the aggregate opinion? Because that is how asset prices are set. Our personal opinion has little-to-no impact on aggregate demand or the value of the investments we hold. Our objective is to stay aligned with the market’s pricing mechanism.

If you are thinking “the chart above has been skewed by the Fed’s demand for Treasuries”, the chart of stocks versus aggregate bonds (AGG) tells the same story.

Would The Poll Have Helped Us In 2007-2008?

The number one way to impact investment performance is to have the proper allocation between risk assets (e.g. stocks) and defensive assets (e.g. bonds). The sharp and pronounced downtrend in the chart below provided a clear “risk-off” signal in late 2007 and 2008.

Would I Rather Be Long Or Short?

The same economic and inflation-related concepts impact the demand for stocks relative to shorting stocks (SH). Short positions “go up when stocks go down”, meaning they represent a bearish bet on the economy and stock market. The long/short ratio is not pointing to an imminent stock market correction.

Sprint To The 2013 Finish

The S&P 500 chart below monitors the battle between “I am confident about stocks” and “I am concerned about stocks”. The blue and red lines are moving averages that help smooth out week-to-week volatility, allowing us to focus on the dominant trend. When the blue line is above the red line, the winner is “I am confident about stocks”. When the blue line drops below the red line (see A and B), the odds of a stock market correction increase. The current look of the chart is not pointing to an imminent sustained pullback in equities.

Dow’s Recent Push

The green box on the weekly Dow chart below shows a five month period where stocks in the index made little-to-no progress. Inside the green box, bullish and bearish economic conviction were evenly matched. When investors pushed the Dow above the green box, it represented a victory for the economic bulls. As of Tuesday’s close, the chart below looked healthy and favored bullish outcomes for stocks and the economy.

Technology Aligns With Bullish Case

All things being equal, it is a good sign for stocks and the economy when technology stocks are attracting interest from investors, which is exactly what we have now.

Investment Implications – Intel CEO Nails It

How do we use all this? Let’s start with a question - why are there so many polls taken during a presidential election? Voters change their minds as they process new information, which is exactly what happens in the financial markets. The little blurb from Yahoo Finance below on the key to business success also applies to the financial markets:

Adam Levie has successfully run a $1.2 billion company for eight years. Levie cites former Intel CEO Andy Grove’s Only the Paranoid Survive as the manifesto that he and most entrepreneurs in the Valley follow: “You always need to make sure that you’re disrupting yourself, watching all of the trends that could potentially disrupt you and always generally have a heightened sense of awareness and paranoia about what could happen at any given time.”

Tuesday, some banter on Twitter started with an accurate observation from an experienced trader (@daytrend) that he is not seeing euphoric or bubble-like behavior from investors. His observation prompted a question from a third trader about how this would end. Our response below eliminates any “he’s a permabull” objections to the analysis presented above.

Just as a successful CEO must always be looking for changes in the marketplace and new trends, we must monitor the market’s pricing mechanism with an open and flexible mind. As outlined in this week’s video, the view from 30,000 feet remains positive. When the polls shift back in to the bearish camp, we must make the proper defensive adjustment to our investment allocations. For now, the polls tell us to continue to maintain exposure to U.S. stocks (SPY), technology (QQQ), financials (XLF), energy (XLE), small caps (IWM), foreign stocks (FEZ), and emerging markets (EEM).


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