Correction, Interrupted

Dice with pencil on graph paper

By Cam Hui :

The analysis of financial markets has a low signal-to-noise ratio. Under those circumstances, good traders need to learn to admit when they were wrong and I am prepared to do that. Regular readers will know that I have been fairly cautious about the intermediate term outlook for U.S. equities and I have been calling for a correction this summer. However, with the SPX pushing to new highs last week:

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...and major European averages rallying to new highs in anticipation of another round of ECB stimulus:

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It's time to throw in the towel on the correction scenario (as did Dennis Gartman and Ralph Acampora last week).

I have not moved to the bull camp, like BoAML which came out last week with a forecast of a market melt-up, following by a nasty correction . However, I do believe that stock prices will remain range-bound in a choppy fashion until new developments cause the market break up or down. That's because a number of forces are combining to either be supportive of stock prices and to put a lid on rallies.

Let's go through the bull and bear cases.

The bull case: Earnings outlook still positive

In a recent post (see Time for a growth scare? ), I wrote that one of the critical drivers of stock prices is the earnings outlook. As Ed Yardeni pointed out, forward 12 month consensus EPS estimates continue to rise. In the current macro environment, rising EPS estimates are supportive of higher equity prices. Note how the red line in the chart below, which represents forward 12 month consensus EPS, is rising to new highs and past periods when the slope flattened out were associated with market corrections:

Bullish insiders

As optimism for earnings growth rise, insider activity has also flashed a big signal (via New Deal Democrat ):

Hedge funds in a crowded short

As well, BoAML pointed out that large speculators (read: hedge funds) are in a crowded short in SPX, NASDAQ 100 and Russell 2000 futures:

I was the original author of the Hedge Fund Monitor and therefore I am very familiar with the data. I would discount the comment about SPX futures as I found that it had relatively low predictive value. However, extreme readings in large speculator futures positions in the NDX and Russell were good contrarian indicators of market direction for the next few weeks.

Late cycle and defensive sectors are faltering

In addition, a main reason for my cautiousness has been based on the signals from sector rotation as late cycle resource sectors and defensive sectors had been turning up to assume the mantle of market leadership. These were signs to be cautious about stock prices (see The bearish verdict from market cycle analysis ). Since then, late market cycle leadership has stalled.

The chart below of the relative performance of European Basic Materials against DJ Europe and Metals and Mining against the SPX both show a similar pattern of near-term relative weakness.

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The chart below of the relative performance of the Energy sector against the SPX indicate that this late cycle sector rallied hard on a relative basis, but they got overbought and have started to roll over.

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I also constructed an index of equally weighted defensive sectors of Consumer Staples ( XLP ), Telecom ( IYT ) and Utilities ( XLU ) and measured their performance against the market. I deliberately excluded Healthcare, which is thought to be a defensive sector, because of the performance of biotechs have muddied the waters. As the chart below shows, past corrective periods have been marked by a rally out of the relative downtrends shown by dotted lines, which are followed by relative upturns. The current episode was marked by the rally out of the relative downtrend, but the relative upturn by the defensive sectors is missing.

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The bear case: Inflation ticks up = Rising short rates

While these factors are likely to put a floor on stock prices, there are a number of bearish factors that are likely to put a ceiling on any major advances by the stock market averages.

First of all, inflation is starting to tick up and that could cause an interest rate scare about the timing of tightening action at the Fed. This chart from Doug Short shows the Fed's favorite inflation metric, Personal Consumption Expenditure (PCE), is ticking up.

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Any way you look at it, core PCE is rising. The Dallas Fed has an alternative measure, called Trimmed Mean PCE, which strips out the most volatile components of PCE instead of just food and energy. As the table shows, one-month core PCE inflation has been above the Fed's own target of 2% for two straight months. The one-month Trimmed Mean PCE inflation rate has doubled from 1.2% to 2.5% in the space of two months. As well, the various PCE inflation rates measured over longer six and twelve month time horizons are rising.

If the Fed were to mention rising inflationary pressures at the statement after the next FOMC meeting, it would be interpreted as a hawkish statement that could therefore spook the markets.

Cyclical stocks still weak

I would also reiterate my concern that the CapEx cycle has yet to kick in for this recovery. At this point of the expansion, companies should be hiring and buying capital equipment. Ed Yardeni , along with many other analysts, have been expecting a CapEx rebound:

Yet CapEx is nowhere to be seen. While the last headline Durable Goods report beat expectations, core Durable Goods growth was only 0.1%, which missed expectations, and Durable Goods ex-defense and volatile aircraft orders growth came in at an abysmal -1.2%.

As a measure of the market expectations of the CapEx cycle and expectations of economic growth acceleration, the relative performance of the Morgan Stanley Cyclical Index against the SPX has been rolling over. Could a growth scare be around the corner?

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What is comforting to the bull case is the expectation of a rebounding U.S. economy, which is becoming the consensus view. In his latest weekly report on high frequency economic releases, New Deal Democrat reported:

A glance at the Citigroup U.S. Economic Surprise Index, which measures high frequency economic releases to see whether they are beating or missing consensus, is rising and now roughly at zero indicating a rough balance between beats and misses after the spate of negative reports because of the bad winter. It may be that, with a rebounding growth outlook, we may need to see the Surprise Index rise to the grey target zone where there is an excess of positive surprises before the growth outlook and stock prices correct.

In the meantime, Consumer Discretionary stocks continue to be weak and could be the source of another negative growth surprise. Thomson-Reuters reports that forward guidance for the Consumer Discretionary sector and specifically retailers continues to be disappointing:

Inter-market analysis still signaling caution

Despite the near-term failure of my market analysis (see The bearish verdict from market cycle analysis ), I continue to believe that inter-market analysis is still signaling caution for the stock market. To underline this point, my former Merrill colleague Walter Murphy wrote the following last week (emphasis added):

Low volatility = Rising complacency

In addition, the fall in market volatility is fueling activity that might not be classified as "prudent". For example, the FT reports that investors have been reaching for yield by using the carry trade (borrow short-lend long) to enhance returns. These kinds of comments are signs of a maturing bull (emphasis added):

FT editor Gillian Tett openly fretted about how this kinds of complacency might resolve itself:

So did Josh Brown :

By deja vu, Brown was referred to two important blog posts about the dangers of complacency and the parallels with 2007. At this point, raising the ghosts of 2007 is a bit of exaggeration as there is no recession on the horizon:

Limited near-term upside

Though they warn of rising risk levels, none of the bearish factors that I mentioned are suggestive of an imminent crash in stock prices. In the near-term, however, the upside in stock prices are likely to be limited. Bespoke reports that 8 of 10 sectors in the SPX are overbought:

The SPX just kissed the top of its weekly Bollinger Band, and analysis from Springheel Jack shows that such occurrences have historically served to cap market rallies. He also indicated that punches over the weekly Bollinger Band have historically signaled a downdraft in prices.

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Ryan Detrick recently featured this chart of AAII neutral sentiment, which shows neutral sentiment at 11 year highs. I interpret these readings to mean a jittery market, which could break hard and fast either way, depending on news flow:

When I put this all together, it is suggestive that stock prices are likely to move sideways in a choppy pattern for the next few weeks. While I continue to lean slightly bearishly, I am prepared to listen to the market and change my opinion should developments point to a bullish outcome.

Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). The opinions and any recommendations expressed in the blog are those of the author and do not reflect the opinions and recommendations of Qwest. Qwest reviews Mr. Hui's blog to ensure it is connected with Mr. Hui's obligation to deal fairly, honestly and in good faith with the blog's readers."

None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this blog constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or I may hold or control long or short positions in the securities or instruments mentioned.

See also Meredith Corp. Dividend Stock Analysis on seekingalpha.com

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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