April 2, 2012: Why Stocks Appear Pullback ProneMarket Overview |   April 03, 2012 - 8:59 PM EST
MARKET REVIEW SINCE LAST ISSUE
Since March 19th, the release date of Issue XXVI, United States (U.S.) stocks traded more or less sideways to finish their best first quarter since 1998. U.S. stocks outperformed most of their global peers, which fell mainly due to European and Chinese economic growth worries. A string of disappointing manufacturing and services Purchasing Managers’ Index (PMI) reports across the euro area, in addition to a disappointing preliminary PMI report and a petrol (gasoline) price hike in China shook market confidence. Over the past two weeks, European equity indices fell sharply, with losses ranging from just less than 3% for the German benchmark Deutscher Atkien Index (DAX) to almost 6% for the Spanish benchmark Iberia Index (IBEX) 35. During the same time period in Asia, Shanghai and Hong Kong benchmark equity indices, whose performances are closely tied to that of the Chinese economy, fell between 3% and 4%. The Indian benchmark Bombay Stock Exchange (BSE) Sensex and the Japanese benchmark Nikkei 225 (Nikkei) each suffered losses of less than 1%.
UNPRECEDENTED LIQUIDITY CREATES UNPRECEDENTED PRICES
In my view, the best investment opportunities today do not lie in stocks. As I have discussed many times in the past, liquidity or money supply expansion has been a major driver of global stock market gains since the 2008 financial crisis. Central banks control the money supply, whose broadest form includes the amount of cash and credit in an economy. Since central banks, such as the U.S. Federal Reserve (Fed) and the European Central Bank (ECB), have injected unprecedented amounts of cash and credit into the global financial system via programs known as quantitative easing (QE) and long-term refinancing operations (LTROs), the world money supply has expanded at a record pace. Much of the newly created money has flowed into the financial markets. Hence why so many asset classes, including U.S. Treasuries, stocks, and commodities, are near record levels.
PULLBACK WARNING SIGNS
In my view, the global stock market is due for a pullback for a number of reasons. Historically, early spring is a seasonally weak period for the stock market, which peaked April and May during each of the past two years respectively. Technically, many benchmark indices are at or near resistance, which is concerning given the powerful rally stocks have experienced since last fall. In the U.S., the main benchmark Standard & Poor’s 500 Index (S&P 500) is about 1% away from its 2008 high, and the small cap benchmark Russell 2000 Index came within 2.5% of its all-time high last week. U.S. financial stocks, as represented by the Financial Select Sector SPDR Exchange-Traded Fund (ETF) (Ticker: XLF), are approaching the upper bound of the trading range in which they have been trapped since 2008. In addition, the U.S. dollar (USD) Index (DXY) is near solid support between 78 and 79, which has served as a springboard for past short-term rallies. USD strength sometimes, but not always, is associated with risk asset market weakness, as investors shun stocks and commodities in favor of cash.
In my opinion, Japanese markets have been sending somewhat strong signals too, as the Nikkei consolidated at the end of last week near its medium-term downward trend line. Over the past few days, the yen (JPY) also has consolidated after plummeting to start the year. When the JPY weakens, the Nikkei tends to rise, and vice versa, because the Japanese export industry, a large contributor to Japan’s economic activity, becomes more (less) competitive in the short run when the currency depreciates (appreciates). Based on technicals alone, the JPY appears likely to rally and the Nikkei likely to fall in the near term. The JPY generally rallies when investors feel more risk averse, which tends to lower risk asset prices.
The Nikkei 225 (Nikkei), Japan’s main stock market benchmark, seems to be struggling to break out of its multi-year downtrend. The Nikkei’s inverse correlation with the safe-haven Japanese yen (JPY) may be a sign risk aversion will take hold in the near term.
SHOW ME THE LIQUIDITY!
Fundamentally, I do not see global stocks moving significantly higher without another liquidity catalyst. The last three significant global stock market rallies all coincided with at least one major liquidity boost. The market rally begun in March 2009 was initiated by the Fed’s first QE program (QE I), and the market rally begun in August 2010 was initiated by the Fed’s announcement of its second QE program (QE II). The most recent market rally started last fall, after the Fed pledged to hold benchmark short-term borrowing costs near 0% until at least mid-2013, and the ECB announced its LTRO programs.
The question now is what liquidity program will boost the market next? I do not see more programs coming out of the Western world until at least the second half of this year, because Fed and ECB policymakers must be careful to maintain their credibility and their currencies’ purchasing power. The only liquidity catalyst that I can see pushing the market higher, albeit temporarily, would be an interest rate cut in China, where inflation has fallen significantly since last summer. However, an interest rate cut by the People’s Bank of China (PBoC) would not raise risk assets prices by nearly as much as larger liquidity operations, like QE and LTROs. As such, I feel stock market risks are skewed to the downside over the next few months, or at least until another liquidity catalyst appears on the horizon.
Unprecedented global central bank balance sheet expansion has propelled risk assets higher in recent years. Now that central bankers worldwide are taking a breather, will risk assets do so too?
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