If you want evidence that the US stock market is sometimes frustrating to follow and hard to read, look no further than this morning’s pre-market price action, or rather inaction. In a move that shocked the cynics among us, Congress has announced a bipartisan deal on the budget. The deal is small, but a sign that compromise is possible. This removes one of the major stumbling blocks to continued US economic growth in 2014 and has significantly reduced the potential for damage and disaster from another drawn out fight on fiscal policy.
It would be reasonable to expect a serious rally in response to the good news, but as I write the S&P 500 futures are indicating an essentially flat opening; so what gives? As important as the announcement of a deal is, there are two factors that will be generally quoted as driving the market’s lack of a reaction. There is also a third, more nebulous driver that is, to me, more worrying.
Firstly, the news was already priced in. Over the last couple of weeks there have been several indications that an agreement was imminent, so the announcement itself is no big deal. Secondly, everything pales into insignificance compared to the intentions of the Fed. The idea that the Federal Reserve could begin to reduce bond purchases at the December meeting next week has been slowly gaining traction.
The reaction to any non-Fed news today especially was likely to be muted, as it marks the last day of public comments by Fed officials before the December meeting next week. Three regional Fed leaders will speak today, and their every word will be watched closely for a clue as to the board’s intentions.
Obviously, to a market used to being handed $85 Billion of new money to play with every month, the future of that stimulus is paramount. At the moment, however, that future is generally seen one way. If the Fed does decide to continue with Quantitative Easing at the same pace at next week’s meeting then it only delays the inevitable. It is hard to find anybody who believes that QE at the current rate will still be around after March.
Even given the obvious influence of these two factors, though, this stubborn refusal to react to the removal of what has been quoted as a major problem is surprising to many, but to me it is an indication that sentiment is shifting and a correction of some kind is imminent. I have said many times that whether you are looking at individual stocks or the market as a whole, how traders react to news tells us a lot. When good news is being basically ignored it is likely that the reaction to bad news will be exaggerated.
Let me make one thing clear. I am not attempting to pick the top of the market here or predicting a major collapse. As you can see, that has been a mug’s game all year and long term investors are best off ignoring idle speculation as to what the next short term move will be.
As long as the recovery continues and the employment picture continues to improve, then there is still room for continued gains as multiples of earnings have increased, but are still not excessive. For those who take a more active role in their investments, however, taking some profits and diversifying away from pure market risk may be wise.
The longer we hover below the previous highs around 1805 and the more traders essentially ignore good news, the more it seems to me that they are looking for a reason to sell and lock in some yearend profits. Believe me, if they look hard enough for a reason, they will find one, so a 5-10% drop from here looks more likely than not.
So, if you agree that a correction is likely, but that the long term the recovery is intact, what are your options? Most obviously, you can move to a larger cash position but a zero return and the difficulty of timing your re-entry make that far from ideal. Bonds are not really an option either if you believe that a reduction in purchases by the Fed will be the likely catalyst. That said, if you are of that mind, then buying a floating rate ETF such as the iShares Floating Rate Fund (FLOT) could offer small gains in a rising rate scenario.
I would prefer taking some profit and retaining some cash to buy back on any drop of around 5%, then using the rest to buy stocks that have little or no correlation to the broader market and represent fundamental value. Apple (AAPL) for example has been moving independently of the market recently and, as Jim Cramer recently pointed out, has become a kind of cash proxy for many investors, so will likely outperform in a falling market. Companies that are subject to other risk factors such as Accuray (ARAY) and Chelsea Therapeutics (CHTP) that I wrote about a couple of days ago are more risky, but will largely react to their own influences rather than any short term market movement.
In general, though, for most investors, trading a relatively small, short term correction is neither desirable nor practical. Those that sit tight can take solace in the fact that, if I am right and a drop comes based on the sentiment of traders, they are notoriously fickle beasts. When their sentiment changes it will be marked by a tendency to focus on good news and ignore the bad. For now, though, this morning’s evidence would indicate that they are doing the opposite.