Chills n’ Wrath

Welcome to the rest of 2013.

I certainly hope you’ve made some money in the first five months of the year (which was not hard to have done), because the environment seems to be changing.

Before I continue, I want to remind you that this is a forecast-free blog, we only discuss what is happening and our thoughts on possibilities for the future. If you want a man to predict the future and tell you what to do, you’ll find no shortage of that sort of thing elsewhere.

Okay, just us adults here now…

Here’s where we stand – heading into yesterday the S&P 500, Dow Jones and Russell 2000 had been in a three-way race to outdo each other in the record highs department. All three had been relentlessly ripping to greater heights throughout the spring and just about every sector and sub-sector had joined the rally by early April.

When we didn’t get the traditional Sell in May pullback that so many had been positioned praying for, things just went parabolic for a week or so. Large cap pharmas like Bristol and Lilly began putting up dotcom-esque gains, highly speculative solar stocks began populating the most active lists and hedge funds took their short-squeezing, options-chasing activities into overdrive.

And then before you knew it, everyone was on the same side of the boat again.

What had begun as a gentle, if relentless rally up the side of a Wall of Worry had gotten too easy and the latecomers began making up for lost time. When one shows up to a party after everyone’s already been there for two hours, a few quick shots of tequila are just the thing to “get on everyone’s level”. Goldman Sachs had joined a host of other Wall Street firms in raising their price targets for the S&P after playing catch-up for months – this week they went to 2100 for 2015, which could well have marked the highs for the year.

While we had not quite been at euphoria yet as I’ve discussed, we were probably headed there – multiples were expanding and people began talking reckless. Jeremy Siegel ripped his shirt off and beat his chest on Squawk the other morning while the permabears had mostly flipped bullish. Stocks were missing earnings and rallying on increased dividend and buyback announcements and a feeling of invincibility began to descend. A week ago I had wondered if this was as good as it gets.

And at just this moment – right as we thought we might escape the summer swoons of the past three years – Fear rang the doorbell.

Jon Hilsenrath’s Fed hints of last week had the effect of strengthening the dollar and pushing bonds around a bit but stocks had been unaffected. That is, until Bernanke’s testimony yesterday in front of a joint session of Congress while the minutes from late April hit the wire. Then we printed yesterday’s “red candle” day, an enormous outside reversal – the likes of which we hadn’t seen since February. And this was not just any reversal, but a reversal from a new intraday high on the S&P.

The very frightening statistic that’s been making the rounds overnight is that the last two times the S&P 500 touched a record intraday high and then closed down more than 1% from that high were October 11, 2007 and March 24, 2000, the last two major tops for the market, both of which occurred before historic crashes.

Compounding this reintroduction of fear into the US market is the Asian sell-off that’s unfolding as we speak. Having rallied 70% since November, the Nikkei is currently in the midst of its 11th worst day since 1950, down over 5% overnight as JGB yields unexpectedly spike. One of the side effects of the finance minister being hellbent on creating inflation is that, well, bonds are not going to sell quite as well at auction once it’s agreed that they’ll be money-losers. A lousy bond auction combined with the contractionary Chinese manufacturing PMI was all the region needed to be thrown into an uproar.

Turning back to the US, Dow futures are currently off 140 points as I write. Now what?

On average, going back as far as we have stock market data, history suggests that we get an average of three 5% pullbacks each year, one 10% correction each year and a 20% sell-off every three-and-a-half years. The fact that we haven’t had so much as three or more down days linked together since December of 2012 and nary a 2% decline year-to-date, I suppose the optimal thing would be to go lower and get that out of the way. The predominant bear case of late has been the absence of a correction and the overbought readings of every sector.

A quick trip down to 1600 on the S&P (formerly resistance, now support) would remove that very valid complaint and set up a new leg higher without the current exhaustion.

A rally back and then failure today will strengthen the idea that a short-term top is in and we’ll spend the summer playing guessing games about the Fed’s next move while stocks correct or tread water. I don’t see a problem with that provided it doesn’t get out of hand. Given the underlying strength in housing, the improving employment trends (that matter more than anything) and the continuing problem of T.I.N.A., it’s hard to see equities going bidless for very long.

In my view, a resumption of the rally from here led by a thinning herd of advancers would actually be the worst thing that could happen. I’d much prefer the cool-off.

And then, heaven forbid, the US economic data actually improves to the point where the Fed can actually take its foot off the gas – well, why would anyone be unhappy about that if it happened later this year?

There was one thing Jon Hilsenrath did say in my interview with him on TV last night that I think is very important and clears up a big misconception. He explained that Bernanke himself will not be using the term “taper” that everyone else is bandying about. The reason why is that the Fed does not want to create the impression that one policy move will necessarily be attached to three or four others. In other words, suppose the Fed were to drop its rate of monthly asset purchases from $85 billion to some less number in one of the next meetings. This could be a one-off action with nothing else behind it, designed to temper the market’s expectations and gauge the effects.

I’d remind you that what Bernanke, as a self-styled “student of the Depression” fears the most, is a premature tightening a la FDR in 1937-1938, just as the nation was finally on the mend. If think that this central bank, which has just spent the last six years patiently reflating the economy, is about to yank the rug out from under it at the last moment, then you haven’t been paying attention.