Goldilocks for US Stocks?
Finally! Stocks have their first 10% or greater correction in over 2 years and their largest price drop in over 3 years. However, within 3 weeks after hitting The Low, prices are right back to new highs. The US remains the cleanest of the dirty shirts and an oasis of calm and liquidity in a world of stagnation and uncertainty. Our modestly growing economy keeps inflation historically low, corporate earnings and stock values rapidly appreciating. The underemployment and stagnant wage environment keeps investors nervously in cash in a very positive feedback loop that so far lacks any hint of cyclical overheating. Investors remain 90% invested in stocks with several years left in this secular stock Bull market in our opinion.
We have remained steadfast every year of this record Bull market forecasting ever higher prices into roughly 2017 before economies may derail and prices potentially enter a major Bear market. In our effort to fine tune entry points for investors stuck on the sidelines or needing to raise cash we have also caught short term inflection point Buys and Sells. The morning after The September top that gave us this 10% drop we warned of an “imminent breakout within days on average of 5 to 7%”. After our correction achieved the 7% objective just 2 days before The October 10% low we advised increasing investment holdings of stocks to 90%. Then the morning after The Low we warned to “expect short sharp rallies” into early November.
The power of the 7% bounce back rally was surprising in its relentless angle of ascent confirming once again the amazing amount of stimulus that is supporting our economy and financial markets. We mentioned many concerns that needed to be resolved for this rally to continue higher short term including containing Ebola, ISIS, Ukraine and a new stimulus in Europe. It appeared that all those worries were addressed at once at the October lows and accelerated the pent up demand seeking alpha buying stocks.
The main concern that lingers is the false promise to date that the European Central Bank (ECB) will engage in another US style Quantitative Easing (QE) program. The ECB wants to print money, but one person stands in the way. Angela Merkel leads Germany and essentially she holds all the cards as the only stabilizing force in the region. It’s unlikely she will green light a Euro QE until either her own economy contracts or a southern neighbor such as Greece , Portugal or Spain panic (watch for any spike in Credit Default Swap rates – CDS). Russian aggression in the Ukraine and their escalation of Cold War tactics vs Western countries increases the risk of a third European recession since 2007. Ironically this potential crisis may be the secret ingredient that unleashes stimulus allowing a Global expansion. For now Ebola, ISIS and Ukraine are not causing major concerns.
Stocks Short Term: Technicals
The V shaped 10% correction and 12% recovery to new highs barely gave us a chance to send out advise to Buy a couple days before and after the actual low. The 3rd Quarter Mid-Term election year cycle low we had expected all year finally arrived in October and now supports a further rally that is perhaps too widely expected into early January. While short term momentum indicators are now back to overbought, breadth is strong and trader sentiment is still closer to a Buy than a Sell.
The Put/Call option ratio (right) shows a strong Buy signal right at the 10% correction low which we identified at that time. However, the 4 week price surge since then has yet to swing traders back to excessive optimism (Bullish).
Historical price seasonality (left) has roughly tracked actual prices and has led most to expect a further surge into year end as well as into next Spring. There may be too many expecting a surge, but the indicators and power of the October bounce hint that any dip will be bought quickly.
AAII survey of small investors along with Investment Advisory surveys have surged back to over optimism. This is not cause for alarm as these surveys rarely coincide with market turns.
Thus near term there may be a shallow pullback and trading range for a few weeks, but sideline money will be waiting to flood back into the market at each opportunity.
The caveat emptor fear of Global slowing emanating from Europe is likely the primary concern of something more serious near term.
Long Term: Factors supporting stocks are numerous even after stocks having achieved the 4th longest Bull Market in history. Let’s review:
Yield Curve: A positive sloping yield curve combined with Central Banks determined to provide unlimited monetary stimulus adds tremendous confidence of continuation of expanding economies and rising stock valuations. The Yellow flag from interest rates will occur when the Yield curve approaches inversion (short term rates higher than long maturities). Virtually all Bear markets in stocks occur from a plateau of an overheating economy with sharply rising interest rates to quell inflation. With wages and job quality poor there are no animal spirits here to worry about on the horizon. It’s virtually impossible for the Yield Curve to invert with the Central Banks guaranteeing to keep short term interest rates near zero until the economy expands at faster pace in a self sustaining manner.
Short Interest: When there are no bets to profit from lower stock prices (borrowing stock to go “short”) as reflected by low levels of Short Interest it could be a point of modest concern. However, as this chart illustrates, Short Interest in US stocks is extremely high which almost always coincides with much higher stock prices for months to follow. Short interest levels now are right back up to the the same levels as witnessed at the very bottom of the Great Recession panic low in early 2009 despite the fact that stocks are hitting all time record highs today.
Corporate Repurchases: Large cap US companies have achieved record profits and with a surplus of labor and excess capacity they have accumulated record cash levels approaching $2 Trillion. Paying higher dividends to investors and buying back their own stock to reduce supply are currently the best options in managing cash flows. With slack in the economy and low interest rates we would expect stock buyback programs to continue.
Foreign Buying: When foreigners are buying record levels of US stocks it will be a time to be vigilant for a potential stock market peak as shown by the red circles in this chart to the left. However, when foreign purchases are low and start a more secular rise it is invariably a time to Buy stocks for a couple more years. Despite the huge market advance this chart argues that we need a Global recovery to join the US and send more investment $’s our way. This chart is courtesy of the PFS group at Financial Sense who share very original perspectives.
Overheating Economy: Bear markets in stocks throughout history virtually always occur with an overheating economy. The US has been the strongest economy in the world in recent years, yet there is plenty of slack. Shown here is Germany, the engine of growth in Europe. Yet Germany needs to move to 4% or greater GDP rates before concerns of inflation and overheating are possible. Expect Europe and Germany to be more in sync with the US before stock markets peak.
Summary: Stronger economic growth, tighter yield curve spreads, excessive US corporate, small investor and even foreign buying should be expected prior to a major market top. In addition we note that cycles are supportive. In recent decades 5 to 9 year up trends in stock prices have been the norm. Given the excess cash and lack of Global growth with growing pent up demand we suspect this up cycle will be closer to 8 to 10 years from the 2009 beginning. Should Europe and or China finally adopt a more stimulative policy we could witness a powerful US and Global growth phase.
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