Is a Stock Market Correction Overdue?

Wallace Witkowski of MarketWatch reports, Is a stock market correction overdue?:
Trading volume and volatility are dragging along low levels as stocks reach new highs. That’s made for a nervous complacency where a correction could really blindside investors, some stock pickers are warning. The CBOE Volatility Index (VIX) closed at its lowest point since Feb. 23, 2007 on Friday. It bounced back 4% to 11.18 on Monday even as stocks logged slight gains.

So what is the likelihood of a correction? Take these statistics from the WSJ’s data group:

The Dow Jones Industrial Average (DJIA) experiences a bull market correction on average roughly every 12 months, their analysts note. The Dow is now up approximately 59% from its last correction low on October 3, 2011 and is on its 32nd month without a 10% pullback.

Most investors are extremely and complacently bullish and are ignoring weaker seasonal historical trends that occur around this time, said Brian Belski, chief investment strategist at BMO Capital Markets.

Near-term, while many acknowledge that a pullback is coming, there’s too much complacency and that makes a surprise pullback very likely, according to Belski. Stocks have already spent half the year clawing their way back to low-to-mid single digit gains for the year after an initial drop that followed 2013’s 30% gain.

“I would be super careful as an investor being uber, uber-bullish right now after the huge move,” he said.

Still, at its healthiest, a bull can run for quite a long time without a pause. The longest period without at least a 10% pullback was during the 1990-1997 run, at 82 months, according to the WSJ’s data group.

Sam Stovall, managing director of U.S. equity strategy at S&P Capital IQ, said in a recent note that market bears have been eating a lot of crow lately but may soon see some vindication:
The S&P 500 (SPX) is certainly overbought, in our opinion, and has gone well beyond the time in which it typically endures a correction or worse (the 500 has advanced for 32 months without a decline of 10% or more, versus the average of 18 months since 1945). In addition, valuations on trailing and projected Operating and GAAP (also known as “As Reported”) earnings per share, are equal to their long-term averages.
But Stovall said June may not be the month for the pullback, or at least that’s how it’s happened in the past. Since 1945, the fewest pullbacks on the S&P 500 have started in June with 4%. October had the most with 11%, and May, July , and August had 10%.

Speaking of “overbought,” Jonathan Krinsky, chief market technician at MKM Partners, called the SPDR S&P 500 ETF (SPY).10% “extremely overbought”:
If today closes positive, SPY would be up 14 of the last 17 days. 2 of the 3 down days were -0.05%, and -0.07% (essentially flat). The SPX is now 8.3% above its 200 [daily moving average], which is within a few points of the largest spread in 2014. Of course this spread can get much wider (12% in May 2013), but we have to ask what is the risk/reward over the next few days?
Market complacency is a hot topic these days with everyone wondering how low the VIX can go? Ted Carmichael, formerly running a global macro fund at OMERS, sent me a comment in mid-May, Comfortably Numb, in which he warns:
Past experience shows that while current low levels of volatility have persisted at times for over a year. Investors are lulled into a "comfortably numb" attitude in which they act as if low volatility equates to limited investment risk. Unfortunately, periods of persistent low volatility have often ended with sharp spikes upward in volatility. In three recent episodes, in 2007-08, in the spring of 2010 and the spring and summer of 2011, the periods of low volatility have ended with sharp corrections in equity and credit markets and rallies in high-quality government bond markets. In one recent episode, in the spring of 2013, low volatility ended with a sharp selloff in government bond markets and a more moderate and temporary dip in equity markets.
So far, all the fund managers long volatility (betting VIX will spike), are getting slaughtered and all the ones selling puts are collecting nice premium even though they're taking incrementally more risk to collect that same premium (go back to read my comment on life after benchmarks).

As far as I am concerned, nothing has fundamentally changed since I wrote my Outlook 2014. Sure, the big unwind threw me a curve ball in Q1, but I see risk appetite coming back in a huge way in the second half of the year (which is why I used the selloff to double down on my biotech positions). In fact, momos are coming right back into everything that got clobbered in Q1, namely high beta sectors like tech (QQQ), biotechs (IBB and XBI) and small cap stocks (IWM).

But there are plenty of skeptics out there. CNBC's Talking Numbers had a clip on why this chart spells big trouble for small caps:
Small-cap stocks are making a big comeback of sorts.

The small-cap benchmark, the Russell 2000 index, has retraced more than half of its recent pullback. This comes as the Dow Jones Industrial Average and the S&P 500 indices both make new record highs.

But the technicals may be signaling a huge drop ahead, according to Richard Ross, global technical strategist at Auerbach Grayson.

"I don't like the small caps," said Ross, a "Talking Numbers" contributor. "I'm a seller of the Russell 2000. In fact, full disclosure, I'm short the Russell in my personal account."

Ross owns shares in ProShares Short Russell2000 ETF (RWM), which takes a short position the small-cap index.

Looking at a chart of the iShares Russell 2000 ETF9 (IWM), which tracks the index, Ross sees the potential for a second shoulder in a head and shoulders top. That shoulder is coming close to its resistance level and could fall back again, he believes. The IWM closed at $116.90 on Monday (click on chart below).

"If history holds here, we should rollover and retest that neckline down around $107," Ross said. "That's your critical support."

The longer term chart "really scares me," said Ross and explains why he is short the Russell 2000. The last time it had a head and shoulders top, in 2011, it declined about 27 percent its 150-week moving average. He sees the likelihood of "technical symmetry."

"If this were a head and shoulders top as I put forth, it would be a 26 percent decline" from its recent peak, said Ross. "All we need is that second shoulder and then a rollover. We break below the neckline and we're looking at about a 20 percent drop from current levels. I would be a seller in anticipation of that big move."

Steve Cortes, founder of Veracruz TJM, is more upbeat on the Russell 2000.

"I like the small caps," Cortes said. "Over the last few months, small caps have massively underperformed the S&P 500. In fact, during the month of May, the IWM spent the entire month of May in negative territory for the year 2014 while the S&P spent the entire month of May in positive territory. That kind of a bifurcation between small caps and large is very unusual historically. I think it sets up for a flow of capital, a rotation back into the small guys."

The catalyst for a rotation away from large-cap stocks and into small caps is a stronger U.S. dollar, particularly against the euro.

"A weak dollar makes it easier for those giant multinationals to sell their products globally," Cortes said. "Small caps tend to be more domestic in nature. So, they're not necessarily as sensitive to the dollar trade."

After nearing $1.40 several weeks ago, the euro is now down below $1.36, a three-month low for the currency.

"That bodes ill for the large caps," Cortes said. "It's time for rotation back into the little guys."
I agree with Cortes and as I recently highlighted in my comment on the euro deflation crisis, the euro is heading much lower in the next few years. Last week the ECB implemented a range of measures, including a historic switch to negative interest rates, to help combat the continent's economic woes, but it stopped short of cranking up its quantitative easing (only a matter of time and when they do, gold and gold shares will really take off).

Everybody is getting nervous about the stock market. Sure, CEOs of Fortune 500 companies are buying back their shares at a record pace to juice up their bloated compensation, driving shares higher. The Fed and global central banks are pumping massive liquidity into the system, effectively placing a cap on interest rates and forcing investors to take on more risk.

But as I've been arguing for many years since the crisis erupted, the main threat remains deflation, not inflation, and the power elite will do everything in their power to raise inflation expectations. So far, all this monetary stimulus is helping the 1%, which includes overpaid hedge fund and private equity gurus collecting a 2% management fee on multi billions.

But central bankers are worried that if they don't keep pumping massive liquidity into the financial system, another crisis is imminent and we will experience Japan-style deflation. This morning I read an article that Steve Poloz, Bank of Canada governor and my former colleague at BCA Research, is warning that even with the world’s soundest banks, there are risks to Canada’s economy.

Steve is a hell of a sharp guy. He also reads my comments from time to time and he knows I'm short Canada and have been calling for a major decline in the loonie since December (how many of you got that call right?). I know Canadian bank shares are hitting record levels but I would book my profits so fast and get the hell out of Canadian stocks (since the 2008 crisis erupted, I only buy U.S shares but if you're a Canadian relying on dividends, focus on buying shares which Letko Brosseau buys, including telecoms like BCE and Telus).

The most important thing to understand when gauging these markets is the big picture. I invite all of you to read all the recent comments from Absolute Return Partners, especially their February comment, Challenging the Consensus. Too many of you shorting bonds got killed this year but I think bond yields can rise in the second half of the year as asset allocators book profits and move into risk assets (when you make 5% in bonds in  a quarter, you better book profits!).

I see bond yields trading in a range (2.5% to 3.5%) and think any backup in yields in the second half of the year spells trouble for dividend stocks. What do I see in the second half of the year? I see a major market melt-up in some very risky sectors like biotechs, technology and small caps and while it will be extremely volatile, this is where the momos and elite hedge funds will be focusing their attention. All of you waiting for a major bear market are going to lose a ton of dough!

And what about pension funds? They're in deep trouble, gambling big on alternatives, but they need to get their head out of their asses and start taking more intelligent risks (like investing in biotechs which they are all under-invested in!!). They all need yield, even hedge funds need yield. They will all end up chasing this market higher because they are all under-performing.

It's funny, yesterday I read an article on how Goldman stars fall back down to earth. These are tough markets and I warned all you Soros wannabes to forget about starting a hedge fund. I don't care if you are a "star" prop trader at Goldman, you're going to get killed in these markets. Stick with Goldman, at least there you can make millions front-running your pension fund clients.

I sent that article to a few people. One of them was Francois Trahan, another former colleague from BCA Research and one of the best strategists on Wall Street (now at Cornerstone Macro). Francois closed his hedge fund for personal reasons but he also shared this with me: " my three reasons for winding down was my piece from early May on the new normal ... a world where PEs go up is a shitty one for hedge funds. Nobody wants 2/20 and single digit returns when the S&P500 goes up 30% in a year."

Another hedge fund manager shared this with me:
I also think that once a trader moves from the confines of a prop desk, with its near infinite supply of low risk capital, to a place where they have to draw on capital that likely includes their entire net worth, that they assess risk/return in a different way. Also, when you have to start factoring in things you never really had to deal with when trading at the bank - commissions, margin limitations imposed on you by your prime desk, etc.

Also, it takes a lot of time to either replicate or match the trading systems that they had at the bank. I know at our firm, it took the one partner (who handles the trading platform) months to build everything and integrate with third-party systems. I know he wasn't really happy till a couple of years after they opened up and to this day he spends a considerable amount of time tweaking and refining it. So if these guys are true traders, rather than more cerebral research types (who trade once in blue moon), and they don't have a technical background, it can be very difficult to be the same trader you were at the bank.

Also, once the market closes you have start your second job as small business owner. That doesn't help thing at all.
Bottom line, as I wrote in my comment on the Tiger fund burning bright, most hedge funds stink and there are too many bozos who think they can run a hedge fund that are going to get their heads handed to them.

How is my little (one man) hedge fund doing? Well after a minor setback in Q1, I'm confident I will do well in the second half of the year. You see I couldn't care less what David Tepper is saying on television (Tepper has personal problems to attend to). I focus on what elite funds are buying and selling every quarter and I track over 1000 stocks in over 60 sectors and industries.

In particular, every day I look at the most active, top gainers and losers and add to my list of stocks to track. I also like to know which stocks are making new 52-week highs and lows, which stocks are being heavily shorted, and which ones offer the highest dividends.

Admittedly, my focus nowadays is on small cap biotechs (I'm a high beta junkie whore!). I'm long a few stocks in the Baker Brother portfolio (tickers I like are BCRX, CYTR, IDRA, PGNX, and XOMA with IDRA being my largest holding). I also tweeted to load up on Twitter (TWTR) when it recently fell below $30 and think a lot of top hedge funds jumped in on that selloff.

On Monday, I was scanning my biotechs and what did I see? Click on the image below (a snaphot of the many biotechs I track):

You can see that Idenix Pharmaceuticals (IDIX) was up 230% as Merck agreed to buy it for $3.85 billion (Achillion Pharmaceuticals (ACHN) also doubled in last couple of days). My mind immediately went to Seth Klarman at Baupost Group which holds 35% of the outstanding shares. You'll recall Seth Klarman is the mentor of David Abrams, the one-man wealth machine I recently wrote about. They both charge hedge fund fees for picking stocks and they are among the best deep value investors in the world (this doesn't mean they're always right!).

What's my point? My point is who cares about big proclamations on where the stock market is heading. Focus on where elite fund managers are actually putting their dollars at work and focus on reading these markets right, especially the big macro trends.

Below, market has gone years without a correction, but is that a reason to cash out and put your profits under the mattress? UBS strategist Jeremy Zirin sits down at the MoneyBeat desk to talk stocks.

Also, with global markets on the run with better-than-expected news from China, the FMHR traders discuss if anything can derail this rally. Stephanie Link says you may not have a massive correction just a continual rotation.

I see a rotation in RISK ON assets for the second half of the year and that's where I'm putting my money to work. Once again, I'd like to remind all of you, especially pension fund managers, hedge fund managers and private equity managers, to kindly subscribe to my blog (go to the top right hand side and use PayPal). Please join others and subscribe using the $500 or $1000 a year option. That's cheap considering I will make you a bundle on my market calls!!! :)