The Summer Pullback?

A surprisingly bleak forecast for the world economy pushed stocks to their biggest loss in two months.

Major stock indexes tumbled by more than 2 percent Monday, sending the Dow Jones industrial average down 201 points, after the World Bank estimated the global economy will shrink 2.9 percent in 2009. It previously predicted a 1.7 percent contraction.

The grim assessment was the latest unwelcome surprise for the market since last month and further eroded hopes that the economy was starting to emerge from recession. Investors began driving stocks sharply higher in early March, encouraged by modest improvements in housing, manufacturing and even unemployment.

The dampened economic outlook from the World Bank, a global lender based in Washington, also weighed on the prices of oil, metals, and other commodities. Those price drops in turn sent energy and metal producers' shares falling.

Hugh Johnson, chief investment officer of Johnson Illington Advisors, said the downbeat economic prediction confirmed fears that have been building in the market for two weeks.

"The forecast by the World Bank just dramatized that the market may have overstated what's coming for the economy," he said.

The stock market is coming off its first weekly loss in more than a month after mixed economic readings last week.

Investors have gone from enjoying a string of better-than-expected economic data to trying to manage a list of worries about the economy. Stocks have lost ground several times in the last month on fears that rising interest rates and inflation would upend an economic recovery.

Many analysts also say the relief that erupted in early March about the economy then led to outsize expectations for how quickly a recovery could occur. Other economic news has hit stocks since May. A disappointing government report last month on retail sales suggested the economy remained fragile, and the Federal Reserve reined in its expectations for how the economy will fare this year.

There were no major economic reports Monday, but traders will get data this week on new and existing home sales, durable goods orders, gross domestic product and personal incomes and spending.

The Federal Reserve also will be in the spotlight after its two-day meeting on monetary policy ends Wednesday. The central bank is widely expected to hold its key funds rate steady near zero, but investors want to know whether policymakers will say the economy is recovering or still in need of aid.

The Dow fell 200.72, or 2.4 percent, to 8,339.01, its lowest finish since May 27. It was the biggest drop for the blue chips since losing 290 points, or 3.6 percent, on April 20 as investors worried about the soundness of bank balance sheets.

The Dow has fallen for five of the last six days and remains down for June.

The Standard & Poor's 500 index fell 28.19, or 3.1 percent, to 893.04, also leaving the index with its biggest slide since April 20 and erasing its advance for the year. The Nasdaq composite index fell 61.28, or 3.4 percent, to 1,766.19.

After Monday's drop and a 3 percent slide last week, the Dow is down 5 percent for the year. The Nasdaq, however, remains up by 12 percent in 2009.

The market is selling off on the uncertainty of what lies ahead, said David Kotok, chairman and chief investment officer of Cumberland Advisors.

"The picture's not clear. You've got a market that's acting just that way," Kotok said.

Bond prices jumped Monday, pushing yields down, as the drop in stocks drove demand for the safety of government debt. The yield on the benchmark 10-year Treasury note sank to 3.69 percent from 3.78 percent late Friday.

So what was the big deal about the World Bank forecast? After all, Yves Smith notes that the forecast was cut in mid-June so why did markets take notice now?

One of my buddies sent me an article, Insiders exit shares at fastest pace in 2 years as market rises:

Executives at US companies are taking advantage of the biggest stock-market rally in 71 years to sell their shares at the fastest pace since credit markets started to seize up two years ago.

Insiders of Standard & Poor's 500 Index companies were net sellers for 14 straight weeks as the gauge rose 36 per cent, data compiled by show. Amgen Inc. Chairman and Chief Executive Officer Kevin Sharer and five other officials sold $US8.2 million of stock. Christopher Donahue, the CEO of Federated Investors Inc., and his brother, Chief Financial Officer Thomas Donahue, offered the most in three years.

Sales by CEOs, directors and senior officers have accelerated to the highest level since June 2007, two months before credit markets froze, as the S&P 500 rebounded from its 12-year low in March. The increase is making investors more skittish because executives presumably have the best information about their companies' prospects.

"If insiders are selling into the rally, that shows they don't expect their business to be able to support current stock- price levels," said Joseph Keating, the chief investment officer of Raleigh, North Carolina-based RBC Bank, the unit of Royal Bank of Canada that oversees $US33 billion in client assets. "They're taking advantage of this bounce and selling into it."

I always track insider selling activity but the truth is that very few insiders are good market timers. Most are horrible market timers and often sell at the worst possible time, so I wouldn't read too much into this.

There are no shortage of bears out there. Charles Nenner of the Charles Nenner Research Center uses some unorthodox methods to predict the markets. The former market-timing consultant at Goldman Sachs has made some stellar calls, including:

  • Forecasting a Dow peak of 14,500 in the summer of 2006.
  • Calling the market top in October 2007.
  • Forecasting in late 2007 a “deflation scare” would occur in 2008, something he says isn’t over yet.
  • In February 2009, predicted a major rally would start “in a few weeks” and could take the S&P as high as 1000.

So what is he saying now? After some short-term gains to coincide with month-end window dressing, Nenner predicts the stock market will turn south, possibly sharply.

“I’m still worried we could test the lows,” he says, suggesting a break of S&P 850 would make that grim outcome a near certainty.

Check the accompanying video for more on Nenner’s analysis, including some insights on how he uses the past to predict the future.

I exchanged some thoughts with Martin Roberge, Portfolio Strategist and Quantitative Analyst at Dundee Capital Markets to get his views on the pullback. Martin told me that he was not too concerned about today's selloff but the volatility is keeping investors on the sidelines longer. He was disappointed with the poor performance of Canadian stocks on Monday.

He added that he expects stocks to rebound from here but he warned me "stocks are driven by technicians and this is bad because technicians are bearish".

In a recent research report, Martin notes the following:

In our recent monthly strategy wires, we argued that equity markets were behaving no differently than following other bad years for equities, in which there is a clear pattern for the stock market to bottom in the first quarter and stage powerful bear-market rallies in Q2-Q3. Exhibit 1 provides an update as to how we are tracking this pattern so far. Needless to say, the ongoing consolidation is not unusual at this stage in the rally. Importantly, this post-equity crash pattern reveals that there could be important performance-chasing activities over the next few weeks, especially if the S&P 500 manages to stay above 900, the high-water-mark for the year.

That said, while Exhibit 1 (click on chart above) suggests that equity bears could be fooled again by end-of-quarter buying forces, it also shows that the equity market advance since March lows could hit a brick wall in July-August. This perspective is among factors that have led us to reduce our overweight equity exposure last month. Also, our next monthly strategy update will shed more light as to why the 4-month market recovery may not represent the beginning of a new bull market. The crux of our argument revolves around the competitive return offered by real corporate bond yields above 5%.

Bottom line. The post equity-crash pattern suggests that fears of a market breakdown are premature. Equities should be re-energized by end-of-quarter buying forces and performance-chasing activities. History suggests that the back half of Q3/09 is likely to be more challenging.

While I agree that the second half of the year will be tougher than the first half of the year, I still feel that there is a lot of performance anxiety among the bigger funds and these dips will be bought. I am watching the 50-day and 200-day moving averages on the major indexes and how we will close this week.

You should also note that the U.S. Securities and Exchange Commission may force investors to disclose derivative stakes in companies, a step that would make it difficult for hedge funds to accumulate equity-swap positions without tipping off targets. This rule will make it harder for hedgies to short this market.

Can we retest the March lows? Sure, why not? But there is a fundamental difference now compared to March or November of last year.

Importantly, all financial stress indicators are nowhere near where they were back then. This does not mean that I don't have concerns going forward.

Jean-René Guilbault, a former colleague of mine at PSP Investments who worked in real estate, sent me an article on where U.S. housing will be in 2012. He added these observations:

Key Points: US House prices might drop by 16% this year... with recovery in 2012... Surpassing Bank's stress test worse case.

Opinion: There is a saying: "When Real Estate (RE) construction goes well the whole economy goes well." But the RE construction cannot go well if there is tons of residential properties on the market without any buyers and a high unemployment rate that brings in low consumption. This makes me rephrase the previous words of wisdom to the following: "When the US residential market will do well the whole US economy will be on the recovery."... with this observation and based on the article in reference, we could believe that nothing will be on the up side in the US economy until mid-2010...

[Leo's note to traders: If you want to play the short side of real estate, trade the Ultrashort Real Estate Proshares (SRS). If you think financials are going to get clobbered, then trade the Ultrashort Financials Proshares (SKF).]

Another former colleague of mine at the Caisse, Luc Vallée, wrote this comment on green shoots in his blog a couple of days ago:

People are seeing green shoots everywhere these days. In the economy and now in Iran; it is spring after all. Yet I believe that all these green shoots still remain only wishful thinking. I am not counting on them to reach anything remotely close to full bloom anytime soon but, as a market observer, I am definitively keeping an eye on both buds to manage my risks. I can’t deny that they have long term potential to flourish and that they may evolve in unexpected ways in the short term.

What is most relevant for now is that the risks of these events are not similarly accounted for in the markets today. The “risk” of a quick economic recovery is probably more than fully priced in the U.S. stock market. Given that it is still a low probability event for 2009, the current rally could thus be short-lived.

On the other hand, the risk of another Iranian revolution that would, for instance, topple the clerics and replace the regime by moderates (admittedly a lower probability event and a much more difficult one to play) has not had any discernable or significant impact on the markets yet. Part of the difficulty for market participants resides in evaluating the probability of such an event and judging whether such a revolution would bring more stability or more unrest to the region.

The potential for more instability in the short-term is real if current demonstrations can gather steam. The most likely scenario for now is the status quo. I expect Moussavi’s supporters to gradually go home quietly within the next few weeks. Yet the potential for a significant market event is still very much a reality and represents a risk that has not been priced by the markets. In other words, markets are still treating the recent demonstrations as non-significant.

This could be because market participants are not falling for the media hype about the events in Iran. The “media hype” scenario has some merit. By this I mean that it is possible that many of us are making a big deal out of the events in Iran just because of the Western media’s reaction to them. Here are my thoughts on the issue. One the things that struck me during the last couple of days is that the US media is still very much in a pre-emptive strike mood. They see it as an american responsibility to support the opposition in Iran.

In other words, they are not only wishing for democracy and freedom in Iran, they are also wishing for action on the part of the U.S. government. Read Charles Krauthammer in the Washington Post to see what I mean. Although not everyone is as radical as Krauthammer in calling for Obama’s support of Moussavi, the wishes of many journalists are that Obama should “do something”. Even the Democrats are at it. Bill Maher is starting to take jabs at the President for not acting with more audacity and Thomas Friedman, in subtle ways, is wishing that "our social networks" are going to do the job of toppling the Mullahs.

Haven't we learned that unexpected consequences are the lights that we perceive at the end of the fog of war tunnel? Mirages do not exist in the desert. They exist in our mind. They are the product of tricks played by nature on our mind. They can also be the result of tricks ideological constructs play on our values: We hope and foresee democracy and freedom in the Middle East but we get war and death once we reach destination.

Hubris and hopes are not so distant from one another. The making of one or the other is often determined by the wisdom (and luck) of those who lead us. This is the dilemma we are in right now. I thus understand President Obama's reluctance to get involve in Iranian affairs, in yet another crisis or to provoke or accelerate its occurrence. It’s not that he has already so much on his plate right now but what would be the consequences of his intervention? This is, without a doubt, a question that weights heavily on his temptation to get involved. But isn't this why we elected him? To change the world? Isn't he the one with the wisdom? the good ideas?

George Bush had no wisdom, no good ideas and was not intellectually curious according to his detractors. He was hubris; even if to his supporters, he was just plainly unlucky. If he could only have found these WMD, if only Katrina had struck under Obama, if only the financial crisis could have waited just a few more years to unfold, etc.

But Obama? He is hope. He has the audacity of hope, not the arrogance of hubris. Yet, assuming Obama has the wisdom, he would still need to be lucky to pull this one off. And maybe he has enough wisdom to know that. I don’t know. All I know is that it is possible that our hopes (or hubris for that matter) for democracy and freedom in Iran are not in line with the reality on the ground in that country. And that the most likely scenario I alluded to above is the only scenario ... at least for now!

This could explain why the markets haven’t budged. Sometimes markets know better; but sometimes not. The risks appear to be real. Have a look at videos 8, 9 and 10. It’s definitively a story to follow.

Geopolitical tensions in Iran can easily degenerate from here. But a terrible situation does not have to degenerate further. Fareed Zakaria sat down with former National Security advisor Zbigniew Brzezinski to discuss the Iran election crisis. I urge you to carefully listen to his comments.

Where will the markets head in the months ahead? I am watching to see if the dips will be bought and I remain cautiously optimistic that despite all the bad news, equities will continue to grind higher.