Wednesday, January 20, 2010

Time For Market Cheerleading To End, And Caution To Reign

. Wednesday, January 20, 2010

By Jeffrey D. Saut *

Wall Street’s cheerleaders were at it again last week chanting “I believe” in an attempt to further levitate stocks. Hereto, however, the current difference between perception and reality is somewhat far afield by our pencil. As our friends at the celebrated GaveKal organization deduce, there are basically two options confronting the U.S. equity markets; and, the valuation disparities between the two have rarely been so great.

Option Number 1) “Global growth is just extremely strong and investors remain far too defensively positioned. This would explain the very sharp rally in cyclicals in recent weeks, the rebound in shipping, ports, logistics, materials etc. Of course, if global growth is now much stronger than most expect, a 'bad cop' will at some point have to show up at the party to tell the hosts to keep the volume down. Right now, the G7 central banks seem most unlikely to fulfill that role, focused as they are on preventing another Japan. In our view, this means that the 'bad cop' might have to be the long end of the bond market, though interestingly the yield curve is already about as steep as it has been in 20 years.”

Option Number 2) “Markets in recent weeks have just been running on fumes, driven by year end window dressing / new year repositioning. We should thus be wary of reading too much into market signals. In fact, the effort to catch up to recently winning trades (i.e., to drive deep cyclicals aggressively higher) may now be stalling. In that regard, [the] pullback in commodities and equity markets following China's (interest rate) announcement[s] is interesting.”

While we too have been cheerleaders since the March 2009 “lows,” as we entered the new year we have become more cautious, but not bearish. Like GaveKal, the two options present a strategy quandary. If the central banks start to provide less liquidity, or the U.S. dollar continues to strengthen, or China has begun a monetary tightening cycle, then option 2 is likely the right strategy, suggesting participants overweight technology, healthcare, consumer staples, and select emerging and frontier markets. However, if option 1 remains in force, deep cyclicals, transports, materials, energy, and emerging / frontier markets should be the vehicles of portfolio outperformance. Interestingly, emerging and frontier markets seem to be the winners no matter which option plays, although even here we are cautious.

In addition to the two options, we continue to worry about the rising potential for a geopolitical event and / or a sovereign debt default. Moreover, while in the longer term we still think earnings are going to look pretty good, in the near term we are somewhat concerned. Recently, 4Q09 earnings estimates for the S&P 500 (SPX/1136.03) have been reduced by some 20%. Although we are not predicting it, if those reduction fears extrapolate into participants’ psyche for all of 2010, it implies that instead of achieving the current 2010 consensus EPS estimate of ~$78, the earnings number would be closer to ~$62 with attendant reductions in 2010 year end price targets. While we think the 4Q09 earnings reductions are simply an anomaly caused by corporations attempting to get earnings back in line with what auditors will agree with for year end purposes, it could give the equity markets a “pause for cause” when combined with the other worries we cite. Hence, we remain cautious.

The call for this week: The solar eclipse came and went in “Neverland” between 11:06 a.m. and 2:00 p.m. last Friday with an attendant stock slide that should have stopped participants out of our remaining index recommendations. And, despite all the “Tinkerbell clapping,” the SPX is virtually no higher now than it was after the “opening day” rally on January 4th. Moreover, the number of stocks above their 10-day moving averages [DMAs] continues to shrink, which is the type of action typically seen preceding a stock market correction. Also, the 25-day put / call ratios are at levels consistent with short-term negative conditions, while Friday’s close left the SPX below its recent reaction lows, not to mention below its 10-DMA.

Then there is “Dr. Copper,” the metal with a Ph.D. in economics, which recently recorded a 12-month rolling rate of return in excess of 150%. Historically such a “copper cropper” has marked a “trading top” in copper and telegraphed caution for the equity markets. All of this raises the question, “Is this the week participants quit clapping their hands and Tinkerbell falls back to earth?”

*Jeffery D. Saut is Chief Investment Strategist and Managing Director of Equity Research at Raymond James & Associates.

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