Inconceivable

Courtesy of Lance Roberts of STA Wealth Management

Just recently one of the greatest fairytale movies ever made, “The Princess Bride” had its 27^th anniversary of its release. If you have never seen the movie, you are missing one of the greatest classic adventure tales ever made and something that you will enjoy watching with your children. 

What does this have to do with the financial markets? Just hold on a second and watch this clip first so you will have the right context for where I am headed.

This is the “frame of belief” that pervades in the financial markets currently.  A correction of magnitude is currently “inconceivable” as the U.S. is now “clearly” on a trajectory towards stronger economic growth.  As Russ Koesterich from Blackrock stated recently:

“But good news on the U.S. economic front should help temper worsening geopolitical tensions and slowing growth in Europe.

Of course, a strengthening U.S. economy may have a downside. If the Federal Reserve (Fed) increases interest rates too soon or by too much, markets could be rattled. Another trend to watch: diverging growth. Europe and Japan are still struggling while the U.S. continues to evidence signs of strength.

At the same time, stocks are on pace to finish the year with returns in the mid to upper single digits, and I still expect rates to rise, if only modestly, for the remainder of the year.”

First, the U.S. is hardly showing evidence of real economic strength outside of a “bounce” from the Q1 drawdown and the push from the Fed’s liquidity interventions. This is the same continuing pattern of the “start and stumble” recovery that we have witnessed since the end of the financial crisis as shown in the chart below.

Notice, that absent Central Bank interventions, the economic composite index has failed to show organic, self-sustaining, economic recovery.  Furthermore, even the recent “surge” in economic growth has failed to push the index neither to levels higher than the initial recovery bounce nor to levels more consistent with previous economic expansions since 1974.  With the Fed’s latest iteration of liquidity injections ending this month, the true test of whether the economy is “recovering” is yet to be seen.

Secondly, the recent decline in inflation expectations, commodity prices, and the rising dollar (which will impact exports and corporate profits), all suggest the economy is too weak to stand on its own.  

Those issues are already showing up in rapidly declining earnings momentum and expectations, as shown in the chart below from Societe Generale, does not “jive” with the near vertical ramp in recent manufacturing surveys. Very likely there will be a rapid deterioration in the “outlooks” by companies using “global weakness” as a reason to swiftly guide down future expectations. While it is currently believed to be “inconceivable” that the U.S. will be dragged down by global weakness, the markets face a potential re-pricing of “risk” as expectation collide with reality.

As I wrote in this past weekend’s newsletter, the markets are likely already recognizing these issues.

"Over the last several weeks there has been a very pervasive and steady deterioration in the technical underpinnings of the broader markets with small and mid-capitalization stocks, along with international and emerging markets breaking important supports.

For most investors, that damage, up to this point, has been masked by the rotation of money from "high-risk" momentum plays into the safety of large capitalization stocks found in the S&P 500. However, this past Friday, a critical level of support was violated, along with some other more worrisome signs, which need some attention.

The chart below shows the S&P 500 index from since 2007.

 

I have shown the relative buy/sell signals that have occurred since then. Only the sell signal in 2010 resulted in a "bad" trade due to the quick onset of the second round of quantitative easing in September of that year.

Importantly, the most severe corrections in the market since the end of the financial crisis have occurred ONLY when the Federal Reserve's "liquidity injections" were extracted from the financial markets."

I also outlined the "10-Risks" to the markets currently that will likely continue to weigh on the markets. (Subscribe for "free" email delivery)

Technically Important

These “risks” should not be underestimated. Never before in history has the amount of market participation been so heavily driven by computerized trading. Importantly, most of these computerized programs use some form of technical analysis for executing the buys and sells of entire baskets of securities instantly. The major risk to the markets is the break of widely watched support levels that triggers simultaneous selling across the markets driven by computerized algorithms.

Such an occurrence, as we got a taste of in the May, 2010 “flash crash,” creates a “vacuum” of buyers which causes extremely rapid declines in prices. Such a drop would break further supports potentially triggering “serial selling” as programs continue to generate sell-orders with no readily available buyers. The real danger of a swift sell-off is the potential escalation of margin calls as leverage is currently near all-time highs. The additional forced liquidations would create a negative spiral leading to a dramatic destruction of capital as “panic selling” eventually ensues.

That is what history suggests will happen. While this time is different due to the vast amount of computerized inputs into the markets, the result will likely be the same as it has always been.

The chart below shows the key support levels for the markets that are widely watched with the percentage decline from the recent market peak. While it is “inconceivable” that such a decline could occur, it certainly could not hurt to be aware of the levels that being closely watched.

Many of these levels are key psychological support levels such as 1800, 1750, 1700, etc.  As I stated above, like dominoes, once a key support level fails prices could quickly escalate tripping one support after the next.

As shown, a decline of 18.2% would wipe out all of the 2014 gains and 50% of those from 2013 without technically triggering a “bear market” in the S&P 500. The real problem is that no one knows where the “trigger” point is that escalates a market correction into a full-fledged bear market.  Furthermore, with the economy already growing so weakly, a decline of 18% could cause a contraction in economic growth further panicking the “bulls.”

The point is that there are many risks investors should not ignore. Making up losses is much harder than reinvesting stored capital once a clearer picture emerges. While the current belief that a correction of magnitude in the markets is "inconceivable," I am not sure that word means what they think it means.