Equity Trend Nearing End

The financial landscape in 2011 was significantly different from the aging bull we face in today’s equity markets. The investment world was still fearful and the Federal Reserve Board’s primary objective was to pump enough cash into our economy to ensure investor liquidity, drive interest rates down to 0% and ensure that Southern Europe didn’t fall apart. Everyone remembers Greece and Spain, right? The Fed quadrupled their balance sheet between 2007 and its current value. More importantly, after the 20% decline in stocks in the summer of 2011, the Fed began goosing it again, nearly doubling the balance sheet yet again. Good thing Congress raised the debt ceiling. Finally, 10 year Treasuries were still yielding .7% better than breakeven inflation levels at 3.0% and 2.3%, respectively at that time.

Currently, the Fed is slowing down the stimulus it has been adding to the economy. Note that this is not removing stimulus, merely slowing down its monthly additions. These monthly additions were set at $85 billion per month and currently stand at $45 billion worth of monthly balance sheet expansion. The general perception is that the Fed will stop these monthly additions altogether by October of this year. Furthermore, the fed’s policy has shifted from unequivocally dovish to negotiable. For example, while they’re willing to leave actual rates unchanged, they are making it clear that they’re pulling liquidity also, while they discuss inflationary food and fuel pressures, they’ve made it quite clear that wage inflation is not part of the recent spike. Finally, much of the recovery has been attributed to the housing sector’s comeback but the truth is, industrial purchases of residential properties for the sake of rentals was responsible for taking a huge chunk of the underwater and depressed condo and single family residences off of the market. This is quite clear in the new building permit report, which has shown a steady decline since peaking in September of 2012 and currently sits at 0% change year over year.

The rally argument for, “Don’t fight the Fed,” is over. The fed is becoming less and less generous with each quarter. it’s becoming clear to everyone but the individual investors that the current market environment is turning into a two horse race between bonds and equities. The Fed scared rates higher with their exit strategy yet, rates probably have one significant rally left in them. This rally would be driven primarily by a stock market collapse, a rush to safety in the bond market and finally, extension of QE practices to maintain the price illusion. The alternative scenario is that stocks stall and grind, equity investors large and small take profits in orderly bits and pieces while yield hunters move to cash ahead of higher rates due to an orderly exit strategy applied by the markets as a whole.

Personally, I’ve found it improbable to predict orderly markets since Sept. 11 and the government’s insertion of itself into our economy and directly into our markets.  Right now, individual investors in both bonds and equities are paying through the nose for future performance. This isn’t to say they’re wrong. They’ve obviously been on the right side of the trade thus far however; sentiment levels by most any measure are pegged in the greed to extreme greed territories. Additionally, many of these sentiment measurements are turning lower just short of their all-time highs. This ties directly in with the momentum indicators used to measure the market action itself such as stochastics and moving average convergence/divergence indicators. This implies that the underlying strength of the equities’ trends is not as strong as it appears on the surface. More confounding is the fact that many of these same measurements are just as over revved in the interest rate environment. It appears to me that equities and interest rates are racing each other towards an opening big enough for only one of them to pass.

There’s always another trade. There’s no reason to be in a market you don’t understand. The best method for managing a position in your favor that you don’t understand is by trailing a protective stop or initiating some type of insurance plan. Given the 20% sell-off from 2011 along with the drastically different macro economic themes in place currently, I’m not sure how much the Fed can do to halt an equity decline this time around. Furthermore, I’m not so sure the public would buy into their support the way they did last time. Perception means everything in the markets and it sure seems like bigger players are taking short-term chips off of the table. Recent analysis of the commercial trader category shows their momentum shifting from positive to negative in the Dow and Nasdaq as well as being negative long-term Treasuries while still supportive short-term.  We’ve discussed both of these individually in, “All Set for the Stock Market Top,” and “Gold and Bonds Getting Back to Normal.” We’ll be actively looking to short the stock index futures in the near future. It appears to us that the best odds for making big money in these equity markets may be shifting to the short side.