The S&P continues to make new all-time highs even with the severe drop in bearish sentiment. The number of bears in the Investors Intelligence Sentiment Index dropped to 14.4%, the lowest reading since March 1987. Pretty extreme if you ask me, but that doesn’t mean it can’t go higher. These aren’t normal markets. Overextended or not, you have to respect the price action. Which is exactly why I’ve picked stocks that are currently testing support and resistance. If you’re more comfortable being short up here, don’t bet against the market, short the individual names that look like garbage (for longs: buy strength, not trash). That’s how a short seller survives in markets like these.
I think 2013 can best be described as one of the Great Gatsby’s legendary parties: loud, intoxicating and unforgettable for some. But unless Yellen is planning on adding S&P Futures onto the Federal Reserve’s balance sheet, the liquidity injections we’ve enjoyed for years is likely coming to an end.
A tapering of QE is inevitable. With the federal deficit set to shrink for another year, if the Federal Reserve continues to add US Treasuries at its current pace, it will own over 45% of all marketable 10-year equivalents in the entire US bond market (the Fed monetizes ~15% of all 10-year equivalents per year). Clearly that trend is unsustainable if we are to trust the Federal Reserve when their members reiterate that the central bank is not monetizing US debt.
Markets and Bonds in 2014:
In my experience, it’s pointless to draw up price targets on where markets will close in the next 12 months (I’ll leave that to the pros). Equity markets will do whatever they want to, whether I agree with it or not. My opinion is irrelevant. Instead I’m going to play to my strengths and discuss what 2014 may look like from a macro standpoint. You can make your own conclusions as to whether that’s bullish or bearish for equities. I trust you know what you’re doing:
Bonds: It’s no secret that bonds have gone out of style. This year alone investors have pulled out north of $160 billion from fixed income funds. And you can bet that trend will continue into next year. There comes a point where people who’ve been making 2%-4% for the last few years get sick of turning on their televisions and hearing about the S&P hitting new all-time highs. Everyone has a breaking point. With the Fed slowly cutting back on their purchases sometime in 2014, keeping the longer end of the curve from steepening will be tough (as you move up the curve, the Federal Reserve has less control). Why hold onto bonds when there is a good possibility of another large sell-off?
Focusing specifically on the 10-Year Bond, it likely tests ~3.5%, a major multi-year declining resistance level (watch its 2.45% support on the downside). Remember to keep an eye on important economic data points (retail sales, nonfarm payrolls and ISM to name a few), volatility usually picks up in the bond market following the release.
US Equity Markets:The trend is up and look for that to continue into 2014. While I don’t expect another year of outsized gains, I do see the S&P rising to 1900+ at some point during the year (which is only 5% from current levels). The majority of funds are still under-invested and money has to go somewhere. Europe and Japan have seen enormous capital inflows while the US has been largely left out. The modest increase in inflows likely has a lot to do with exhaustion and valuation concerns.
Since the 2009 bottom, the S&P has outperformed every major market by a wide margin. With the US dollar strengthening and the Fed expected to ease their foot off of the gas, why would investors not focus more on countries where central bank easy money policies are still in its infancy? US valuations are almost 15% higher than many of the other major markets, clearly it makes sense why investors continue to pile into Japanese and European markets even at 52-week highs.
The S&P continues to defy gravity, with the slope of the rally continuing to rise with the market. Currently it looks as if the S&P is trying to start a new leg higher, breaking (and closing) above its rising weekly resistance. Any dips should be met with buyers, as that resistance is now considered major support (a break lower would threaten the validity of the breakout and could be considered a bearish false breakout).
The Dow technically looks very similar to the S&P. Former resistance has now turned into support as new money chases returns. Unless prices collapse below 15800, look for the rally to continue.
The S&P is testing a major RSI resistance level drawn from the last two bull markets. Keep in mind this is a monthly chart and a breakout/breakdown will take time to materialize.
Four quarters of upside has historically been negative for the Dow in the short term. Another important fact to consider: the Dow has been up six years in a row only once.
Divergences in 2013 between the S&P and the NYSE Advance-Decline Index have been met with quick, ugly selling. Be careful at current levels.
Europe: Like with any recovery there will be pockets of strength and weakness. But you can’t deal with a debt crisis without fighting stagnation. Credit isn’t flowing at healthy levels in the Eurozone, and the ECB realizes it may need to do something drastic to shock the economy back into sustainable growth. As it stands, the European Commission expects the Eurozone to expand a lackluster 1.1% in 2014, a forecast that has already been cut multiple times this year. There are two policies that are currently being talked about: negative interest rates and asset purchases. I’m sure you can guess that the latter is the policy most investors would prefer the ECB to undertake. With inflation low and the Euro stubbornly high (partly because of capital inflows), conventional monetary policy isn’t going to solve Europe’s woes. Without overdoing it, I think Draghi would find that QE will take some of the stress off of the peripheral economies that are facing record unemployment. Whether he turns to a Fed-type QE program is hard to predict at the moment (mainly because the Bundesbank argues that any government bond buying program is illegal), but expect something drastic. With banks already awash in European sovereign debt, another LTRO will do little to promote credit growth. Europe may be on the cusp of deflation. It’s in the ECB’s best interests to ward off those threats before things escalate.
Japan: Abenomics will prove to be success or failure in 2014. Together, Abe and Kuroda have boosted growth, devalued the Yen and ended Japan’s deflation curse. But look underneath the hood and you’ll find cockroaches. Since the start of Abenomics, the main driver of growth was not investment or consumer spending, but government spending. Money that the government doesn’t have. In that time, Japanese wages have gone to hell, free-falling for 10+ consecutive months. And Japan’s current account deficit has only gotten worse:
The surpluses that Japan once enjoyed are gone. October’s disappointing data marked the 16th straight month of deficits, the longest streak since 1979. Energy costs have soared. Small domestic companies that provide local jobs are slowly closing their doors and moving on. Instead of reviving the Japanese economy, Abe and Kuroda may instead lead it to its collapse a lot sooner than anyone could predict.
The main event hasn’t even begun in Japan. With the Nikkei testing a major resistance level going back 1995, a break higher would bring a lot of new money back into Japanese equities. On the other hand, if the Nikkei or the economy unexpectedly weakens (possibility due to the sales tax increase), expect Kuroda to come to the rescue and provide even more monetary accommodation.
Emerging Markets: The age of the BRICs isn’t over, the good times have just been postponed. High inflation, slower growth and structural weakness seem to be the common theme in many of these countries. Investors have to be much more selective going forward, avoiding countries with large current-account deficits (such as India, Indonesia).
By slowing the pace of asset purchases, the Federal Reserve has exposed a vicious circle for countries like Brazil, South Africa and India. Yellen will not only have to take into account how Fed policy will affect the US economy, but the world. With capital making its way to the exits, emerging economies will essentially be squeezed, forced to deplete their reserves and raise interest rates (or worse: enact capital controls). But by doing so, they will sacrifice overall growth, which is very important to maintain reasonable employment levels. The risk is that violent protests could become more common, similar to what you saw in Brazil recently. The middle class is being hammered due to high inflation and corrupt government policies. At some point things could destabilize if enough people band together and force change. One of the main reasons China’s President Xi Jinping wants to reform the economy and tackle government corruption is a fear that the people will overthrow the government if their current lifestyle isn’t maintained/improved. Like many things, there are exceptions. As I mentioned before, you have to be selective. If you are looking for safety and want to be invested in emerging markets, take refuge in country’s like Mexico, where a stronger US economy will likely shelter its neighbor from an overseas slaughter.
Everyday when the bell rings we ask ourselves: “what will the Fed do?”. This is what it has come down to. Over in Japan they are proposing the world’s largest pension fund dump government bonds and diversify nearly $1.5 trillion into ‘riskier assets’, no doubt a fancy word for ‘equities’. In Europe they’ve been force-feeding financial institutions the same toxic junk many investors took a haircut on not too long ago. And in China, banks have written off nearly $4 billion in bad loans to avoid mass defaults, at a time when when Chinese companies’ borrowing costs are climbing at a record pace relative to the government’s. How much ugly can be swept under a rug?
Without sounding too gloomy, I imagine 2014 won’t be as easy as buying the dips. Fed rhetoric and forward guidance have caused so much confusion that the market doesn’t know what to price in. Each day bond/equity/forex/commodity traders are forced to interpret mixed messages from whatever clown is speaking. Whatever happened to Bernanke’s promise about a more transparent Federal Reserve? Because from where I’m standing, it looks like they run a circus behind closed doors. It’s ridiculous. A 100 years ago the Fed was created to “supervise and regulate banking institutions” and “maintain the stability of the financial system”. What has it done since? Cause multiple bubbles that nearly brought down the global economy. A job well done boys. Cheers to another prosperous and successful 100 years.
There are many different indicators/studies that an investor can use to measure the health of a rally. Here are a few that caught my attention for being extremely bearish:
The divergence between Dr. Copper and the S&P can be easily explained by the decline/stagnation from global economies. Since 2010, annual GDP growth has declined steadily, thus the demand for copper (and other metals) has also fallen. However, 2013 may be the year that breaks that downturn. Risks that remain: a hard-landing in China (due to over-leveraging and bad debts), inflation and capital outflows (which is partly due to the Fed’s eventual QE taper), monetary/fiscal policies from the BRICS/BIITS (rising rates, falling reserves and Mexican/Brazilian reforms) and possible ratings downgrades (S&P currently has a negative outlook on Brazil, possible downgrade next year).