US stock markets have recently rallied to new 18-month highs as economic reports suggest improving conditions. The long-term outlook remains encouraging for the economy and the stock market, but prospects for another short-term pullback or correction like the one we saw in late January have increased.
First, the factors suggesting economic improvement: The statement from the Federal Reserve following the March 16, 2010, meeting noted that “economic activity has continued to strengthen and the labor market is stabilizing. Household spending is expanding at a moderate rate but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. While bank lending continues to contract, financial market conditions remain supportive of economic growth.” Inflation remains benign as indicated by the recent release of the Consumer Price Index (2.2%/year), industrial production rose for the 8th straight month, and factories are operating at the highest rate in a year (72.7%). Also positive, the Philadelphia Fed Survey revealed significant gains in the six-month business outlook that showed a rise in expectations for new orders, and suggested a majority of manufacturers expect to increase production in the second quarter.
Now let’s review the indicators for a short-term pullback: The S&P 500 had dropped 9.2% from 1,150.45 on January 19, 2010, to an intraday low of 1,044.50 on February 5th. This came very close to the target 10% drop to 1035.40 we suggested in our last Insight (“Correction or Bear Market,” February 4, 2010). With the added luck of the Irish, the index subsequently rallied 12% to 1,169.84 by St. Patrick’s Day (March 17), the highest since September 2008. This was up 75% from the March 2009 intraday low of 666.79. On the same day, the Russell 2000 index was up just over 100% (342.59 to 686.94) from its March 2009 low. Prior doubles in the Russell 2000 have triggered corrections in the past. John Schlitz from Instinet recently identified the following examples: “October 1987 to February 1992 (+101%, followed by a -14% correction), October 1990 to February 1993 (+96% / -8%), July 1992 to May 1996 (+97% / -17%), December 1994 to October 1997 (+99% / -13%), October 1998 to March 2000 (+102% / -28%), October 2002 to December 2004 (+102% / -14%) and March 2009 to March 2010 (+100% / ?). While those events suggest a choppy fire-fight isn’t too far off, keep in mind that only the 1998 to 2000 double resulted in lower prices six to twelve months later.”
Reviewing additional technical indicators reveals overbought conditions where prices are considered too high and susceptible to a decline. This should not be confused with being bearish; it merely suggests that perhaps we have risen too far too fast and might be due for a pullback.
When the stock market appears vulnerable, at Iron Capital we are vigilant in looking beyond technical indicators for potential catalysts that might confirm the view of a short-term move lower. Of particular concern are the uncertainties surrounding the sweeping overhaul of the nation’s health care system, financial regulatory reform, and huge government deficits both here and abroad. Winners and losers in health care may appear obvious (insurers have 32 million new customers), but a closer look reveals a more complicated picture (significant risk of an altered business model peaking in 2014). Costs and benefits for businesses from health care and regulatory reform remain difficult to quantify. Leaving little room for error, these historic changes are occurring while the U.S. is using about 7% of tax dollars to pay debt this year, and almost 11% by 2013.
The point of identifying these risks is so we can position ourselves defensively when needed, while preparing to pounce on undervalued stocks when given the opportunity. Economic momentum appears positive, which should translate to better earnings and higher stock prices, at least before elections this fall.
Todd Smallwood
Director of Trading, Iron Capital Advisors
