Market Surveillance — Emerging Economies Upset Stocks

Fri, JAN 24th, 2014

With equity markets turning sour this week investors have two real choices: 1) PANIC, or 2) breathe.

At this point we don’t yet have  a “correction” on our hands. A correction is generally defined as a -10 to -19% sell-off in the market [bear markets are -20%+]. The current -3% is barely akin to a pull-back [defined as -3 to -9%]. But is this pull-back setting up to be a full-fledged correction? Maybe. Maybe not. Either way, I believe this recent selling is chiefly predicated upon a few items:

1) Recent news out of China [a January PMI that missed the mark; SEC battles with the Big-4 US accounting firms’ Chinese arms; and a ~$496M Chinese trust investment on the brink fanning the flames of systemic debt fear, probably the largest cause of recent anxiety]; and also the rocky emerging market currency behavior of the past couple of days [Turkish Lira, Argentine Peso — both suffering from policy problems, but the latter is experiencing dollar-reserve issues as well]. Taken together, this recent volatility and uncertainty in emerging markets and their currencies are impacting sentiment on U.S. stock markets.

2) Given the increasingly accepted general outlook for 2014 that the U.S. economy is getting better and that the Federal Reserve is on track to normalize monetary policy, rates seemingly have nowhere to go but up. Thus a major related undercurrent in the marketplace in recent months has been — in classic Wall Street fashion — traders overplaying their hand, this time on the short side of the U.S. Treasury market. To wit, short positions in this market have grown quite large, according to data from Stone & McCarthy Research. As a result it appears that, following a big run in the stock market and a big sell-off in the Treasury market, weaker-than-expected Chinese PMI data and a potential credit flap were enough to trigger a flight to quality back into safe haven assets. This lead to serious short-covering in Treasurys and sent markets spinning. This hedge fund driven market flush scenario is of course but a theory, though it’s one that seems to make sense when looking at recent price action and correlations.

3) In my view there remains a meaningful lack of conviction in equities [a contrarian indicator]. Over the past several months everyone has been talking about how “bullish” investors are. That this market has now become too frothy because there are simply no bears to be found … an imbalanced market now top-heavy as everyone crowded to one side [optimism]. This level of bullishness, the thinking goes, is what often shapes market tops. My position is that this consensus sentiment analysis is incorrect and lacks appreciation for a critical nuance. What I have seen [and continue to] is a more bifurcated sentiment landscape. On one side are core equity holders who have conviction in stocks [and have been this way for some time]. On the other are “nouveaux bulls” who just recently came to the party. They have been dragged kicking and screaming into this market. They are, in my opinion, better described as fully invested bears [FIBs for short].These guys lack true conviction; they still dislike and distrust stocks and are gone at the first signs anxiety. And there are a large number of these folks given the variety of conversations I have with investors, including other professional analysts. To be sure, this type of stock ownership is not indicative of ‘too much bullishness.” Fair enough, but why is this important in the context of the recent pull-back? Because I believe we are seeing many of these skittish FIBs now exiting the market after the recent rally. They are trimming positions, cutting exposure and generally taking profits on the first signs of bad news. This retreat back into their bear caves is healthy for the market.

Indeed, this was probably needed after such an impressive rally.

By my count, over the past twelve months we’ve had three different notable pull-backs while the market has moved roughly +30% higher. Each one had their reasons, so to speak, and I don’t see anything out there that suggests that this one is somehow more concerning or fundamentally different from the others. So, how long does this one it last? I don’t know. How low does it trade? Haven’t a clue. Nevertheless it’s worth noting that the majority of the recent pull-backs have been both short and shallow. This is likely a function of money wanting to get into stocks after years of receiving negative real returns in cash and paltry yields in fixed-income. Stocks have crushed other asset classes for nearly five years in spite of rampant fear and loathing; suffice to say, those under-invested used those dips as buying opportunities. Unless we see some grave deterioration in economic fundamentals, I suspect this time is no different.

So, how are we handling this pull-back? For now, we are prudently and carefully watching from the sidelines. We aren’t selling into it. Our macro baseline for both the US economy [it’s doing OK and growth is broadening out] and the stock market [we’re still in a bull market that’s going higher] remain firmly intact. We are closely watching U.S. corporate earnings season, and so far things on this front are tracking along fine.

Jason L. Ware, MBA
Market Strategist, Chief Analyst
Albion Financial Group
(801) 487-3700; (877) 487-6200

About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.