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3 Risks That May Cause Short Term Market Correction

  • Written by Syndicated Publisher No Comments Comments
    July 31, 2013

    Mainstream analysis currently believes that there is no catalyst that could trip the markets into the next cyclical bear phase.  It is important to remember that such events are rarely seen in advance and only truly analyzed in hindsight with much finger pointing and diversion of blame.  However, there are three issues that are coinciding which could lead to a near term market peak.  These are 1) buying capitulation, 2) a “tapering” of bond purchases by the Federal Reserve, and; 3) the upcoming “debt ceiling” debate showdown.

    Buyer Capitulation

    I recently discussed the “bad behavior” by retail investors who generally do the opposite of what they should do as they tend to “buy high and sell low.”   I stated then that:

    “Retail investor’s actions are driven by emotion rather than logic. The chart below shows the investor psychology cycle of investment behavior overlaid against the S&P 500 index. The bar graph in the chart is the 3-month average of net monthly inflows by retail investors into equity based mutual funds. (Note: the data provided by ICI only goes back to 2007, however, I wanted to include the previous market cycle for comparative purposes.) Not surprisingly, net equity inflows have turned positive at the peak of the market in 2011, just prior to the debt ceiling debate debacle, and the current QE driven asset inflation.”

    ICI-NetEquity-Inflows-072513-2

    However, it is not just retail investors that make this mistake but also professionals as well who are forced to chase returns in order to maintain its asset base.  This past week, says BofAML equity strategist Savita Subramanian, it appears the institutions have capitulated – because they are now buying stocks after being such big sellers.

    “After near-record net sales by institutional clients in mid-July, and following five weeks of outflows, institutions became net buyers of US stocks this past week. Flows at extremes can signal a shift in trends, as late last year we saw capitulation by private clients which preceded two months of net buying in by this group. And outflows by institutional clients [year-to-date] are now approaching full-year 2008 and 2010 levels, after which they were net buyers in 2009 and 2011.

    Private clients – who tend to exhibit the stickiest flow trends of the three groups – were net buyers last week for the ninth consecutive week. While their inflows were chiefly due to ETFs, five of the ten GICS sectors still saw net buying by this group last week. Private clients have largely shunned single stocks over the last several years, and in our view, continued purchases of single stocks would suggest ongoing confidence in the bull market. Overall, BofAML clients were net sellers of US stocks last week for the third consecutive week, though the amount (-$843mn) was muted relative to previous weeks. Hedge funds drove overall net sales, and have been net sellers of stocks for the past three weeks.”

    BofAML-Net-Equity-Buy-073013

    Capitulatory buying has historically always been a sign of excessive investor optimism.  As I stated above, professional investors are just as prone to buying into market peaks as the average retail investor.  While there is genuine concern about the fundamental state of the markets and the economy – professional money managers will suffer “career risk” if they underperform their benchmark index for too long.  This is why almost every mutual fund is a closet “index” fund and performance is generally very close to its benchmark.  For retail investors outperforming the benchmark index while the market is rising can be exhilarating.  However, the outperforming the benchmark index by being down 29%, when the market is down 30%, has yet to be declared a victory by anyone.

    The fact that professional money managers are jumping into the market near its all-time peak should certainly raise an eyebrow…or two.

    The “Taper”

    I discussed in “3 Reasons Stock May Stumble Despite Fed” the drive for record highs in the market:

    “As I stated back in February the advance to these new highs was certainly expected as the Fed flooded the financial markets with excess liquidity.  The chart below shows the high correlation between the Federal Reserve’s balance sheet and the financial markets.”

    Fed-Balance-Sheet-VS-SP500-073013

    With economic growth sluggish, earnings and revenue growth weak, and unemployment still elevated there are few fundamental or economic arguments to support the current levels of market valuations.  This only leaves the Federal Reserve’s ongoing dumps of liquidity, currently targeted at $85 billion a month, into the excess reserves of banks which is driving asset prices higher.

    This brings into focus the expectations of a slowing, or “taper”, in the Fed’s bond buying program which will consequently also slow the flows into financial assets.  There has been much speculation about the timing of the change in the bond buying scheme with some estimates as early as September of 2013 to as late as mid-year 2014.   One of the most compelling cases for a short term slowing in the current Q.E. program came from Zero Hedge stating:

    “But the punchline appears when one compares the LTM marketable borrowing needs from calendar Q4 of 2012 when the Fed announced the monthly Open-Ended $85 billion in monthly monetization, and compares it to what the TBAC and the Treasury now expect Q4 LTM borrowing needs will be in Q4 of this year. Bottom line: a 30% drop from $1134 billion to $782 billion.

    Treasury-Borrowing-Needs-073013

    This is a 31% drop in net funding needs, but more importantly to the Fed, the annual amount of Treasury issuance monetized soars from the pro forma 48% in December 2012 ($540bn of $1134bn) to a whopping 69% where it will be if all goes according to plan in calendar Q4 of 2013 when if the Fed did not Taper, it would monetize a record 69% of all issuance (and well over 100% of all issuance with notable duration).

    In summary: a 30% drop in funding needs means a ~25% in monetization need (to avoid destabilizing the already illiquid bond market even more), or QE taper QED.

    If this is correct then a tapering of bond purchases could slow the rate of inflation of market assets.  This could bring into focus the underlying fundamentals that have been long ignored up to this point.

    The “Debt Ceiling” Debate

    Beginning in August we will get into the meat of the next debt ceiling debate.  It is almost becoming a spectacle with Democrats in one corner pushing for higher debt limits, Republicans in the other demanding cuts in spending and Obama as ring master threatening“default.”

    The last round of the “debt ceiling face off” came in 2011 and led to a near 20% plunge in the stock market, the economy almost dropping into recession as, even though the administration was threatening a default on payments, money poured into the safety of U.S. Treasuries pushing yields to then historic lows.

    Debt-Ceiling-073013

    The reality is that the U.S. will not default on its debt payments and, despite rhetoric to the contrary, fiscal reform is not the end of the world.  However, in the short term, the debate, fears of tax increases and offsetting spending cuts could negatively impact stocks despite the ongoing bond buying program from the Federal Reserve.

    Blind Faith

    Of course, these three issues are certainly not the only ones that could impact the financial markets.  China is slowing, the Eurozone is still grinding in a recession and Japan’s economic data is declining despite “Abenomics.”   While the majority of earnings reports have beaten estimates in the current quarter – such a feat would not have been possible if estimates hadn’t been lowered sharply from the beginning of the year.  Revenue growth remains weak which is an indication of a weak macro-economic environment and the recent spike in interest rates certainly doesn’t help matters.

    With stocks near record levels the mainstream expectations are for a continuation of the bull advance indefinitely into the future.  There is currently no expectation for the onset of an economic recession, despite growth estimates for the current quarter dropping to 1% or below, nor any real concern given to the record level of margin debt that could lead to a liquidation spiral.  Market participants have put their “blind faith” into the continuation of the liquidity cycle to keep asset prices inflated until the underlying economics and fundamentals eventually catch up.  Historically speaking, this doesn’t happen.

    There is a rising probability of a more significant short term correction in the near future and the fact that institutional and retail investors are pouring money into the markets “now” has historically been a pretty good contrarian signal.

    Images: Flickr (licence attribution)

    About The Author

    Lance Roberts – Host of StreetTalk Live
    After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.

    Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.

    Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.

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