Friday, April 11, 2014

•    Still overweight stocks, but leadership shift since late February suggests a topping process remains likely.
•    Buying of equity should be deferred as the market approaches a weaker stage.

In our Economic Outlook for 2014, we noted that the calendar year could be divided into stages, with Stage 2 possibly experiencing the biggest correction since at least 2011, but we would wait for technical indicators to confirm the uptrend had been broken before taking any (if any at all) defensive action.

As discussed in previous reports, “the risk and the reward for the stock market will not be beginning to end, but rather during the year.”  The price action of the stock market for 2014 is expected to be far less linear than 2013 and, instead, be defined by stages.

•Stage 1 (January to April?) – Leading into a cyclical bull-market peak, this stage has been characterized by momentum, and a Growth bias over Value.

•Stage 2 (April to September?) – A significant stock market decline characterized by relative out-performance of low-beta selections and dividend payers with reasonable valuations.

•Stage 3 (September to December?) – Following a bear market bottom, the magnitude of the decline will be important in determining sector and asset class leadership, but high-beta selections and a mean-reversion theme are likely.

Four major indicator themes continue to argue support of our expectations: fundamental, macroeconomic, sentiment, and technical.

Fundamental

Price-to-earnings (P/E) ratios have changed little since the end of 2013.  Believe it or not, there are a lot of ways to measure P/E ratios.  Using trailing operating earnings, the P/E remains at about 17.2 (about its historical norm).  Consensus estimates were suggesting that the fourth quarter of 2013 (4Q13) could be the strongest earnings season since 4Q10, when companies were rebounding from the financial crisis.  Expectations were realized, but much of that surge was due to one-off accounting dynamics (again, there are a lot of ways to calculate P/E ratios, and it’s all because of the voodoo of defining the “E”).

Our concern for 2014 is that some of the 4Q13 gains were going to be extrapolated into 2014 (i.e. investors would get overly optimistic in Stage 1, lending to weakness in Stage 2).  The market is not expensive, but it is vulnerable to disappointment.

Macroeconomic

The coldest winter in decades  for much of the country affected economic data, but the trend in economic activity does not appear to have been altered by the weather.  The twelve-month moving average of non-farm payrolls has remained between 168,000 and 205,000 since December 2011.  Modest growth is not expected to be derailed in 2014.

The worst bear markets have been associated with recessions.  So long as recession odds remain low, the downside risk to the market is limited to less than 20%.

Sentiment

When it comes to investing, the crowd is wrong at extremes. But the crowd can be wrong for a long time.  For example, in 1996 investors showed irrational exuberance and “wrongly” bought stocks.  But they made a lot of money being wrong for the next few years.  So while it may be prudent to invest according to measures of optimism or pessimism, it is wiser to watch those metrics reverse from extremes before taking action.

Entering 2014, many sentiment indicators were at long-term highs.  While many of those remain elevated, they have reversed.

Technical

The major stock market indices have struggled to break out to new highs, suggesting waning momentum.  But making new nominal highs (or not) is less significant than deteriorating breath measures, which suggest that fewer stocks are participating in rallies.  Most breadth measures remain positive, but we are beginning to see a divergence in small-cap stocks (for example, the Russell 2000/1000 ratio – small caps relative to large caps – failed to break-out of its 2011 highs).  Since there are more small-cap stocks, small-cap weakness is an indication of a tired market.  Another big change in recent weeks is a shift in leadership from momentum stocks (internet, biotechnology) to sectors of greater perceived safety, a technical indicator that supports the shift of sentiment.

Bottom Line:  We expect more downside volatility for the weeks and months ahead, mimicking our “Stages” expectation for 2014.  New allocation toward equity should be deferred.  It is important to note that there are few signs of any more than a short-term market correction in an ongoing long- term uptrend.