Mr. Market Fails Support

X-factor Report 13 April 2014

by Lance Roberts, Streetalk Live

Over the last several weeks, I have been reiterating the risks that remain in the market. However, I have maintained the allocation model at target levels due to the fact that the markets had done nothing wrong. That all changed this past week.

As I stated in the March 29th report:

“The good news is that, despite plenty of headwinds from geopolitical events, ongoing tapering of bond purchases by the Federal Reserve which is reducing liquidity and weak economic data, the markets have not declined. The index has consistently held support at 1850 and on a very short term basis is beginning to get oversold.”

The first half of the week was relatively benign and on Wednesday the market surged as the FOMC minutes hit the markets. With no signs of increased “tapering,” and filled with friendly language, the markets surged due to the result of two or three media outlets’ duplicitous spin of the FOMC Minutes. However, on Thursday, Mr. Market peaked behind the curtain and did not like what it saw. The markets firmly, and decisively, broke through support late last week as shown in the chart below.

As the King Report for Thursday noted:

“The Fed stated that QE tapering will continue and the pace might increase. Please recall that the last big equity rally occurred when the usual suspects proclaimed that the Fed would reduce its QE tapering pace or stop tapering QE altogether. It was a false declaration.

The traders and investors that succumbed to the B.S. from media shills got caned on Thursday and Friday. It serves them right for reacting to imprecise headlines, spin and algo (HFT) buying.

On Thursday, numerous economists, pundits and Fed watchers echoed our view that the FOMC Minutes provided little new information and internal dissent in regard to future Fed policy is increasing.”

It is becoming clear that the Federal Reserve has gotten itself caught in a liquidity trap.

Furthermore, the new Fed chairwoman doesn’t seem to have the “vocal magic” of her predecessor to calm the markets through Fed speak.

From the NY Times:

“Beyond the broad agreement to continue tapering the pace of asset purchases and the dropping of the 6.5 percent threshold, committee members disagree on just about everything else.”

For example, there is a rising dissent about the extent of slack in the labor market, a debate that continued at the March meeting. Only a few Fed officials suggested the labor market is nearing a new equilibrium, implying the Fed should wind down its stimulus campaign more quickly or risk higher inflation.

There was also a good bit of disagreement about the health of financial markets. Some officials see growing risks to financial stability, including a downward trend in risk premiums, while a majority continues to see those risks as modest and secondary. The problem is that the Fed has never been “ahead of the curve” in spotting excessive risk in the market.

As FTN’s Jim Vogel summed up well:

“Market confidence in its ability to read the Fed is in tatters on the floor. The Fed’s ability to understand the market’s reaction to its communications might be in even worse shape…Unfortunately, the early obsession with the Fed’s plans for 2015 obscures investors’ understanding of the current economy.”

The problem is that the markets have, until now, placed their faith primarily in the Federal Reserve’s ongoing liquidity programs to support their financial manipulations without “risk.” Pushing stock valuations in the stratosphere has been the game as long as the Fed was there to bailout the markets in the event something went wrong. As noted by Savita Subramanian, BofA-Merrill’s head of US Equity Strategy and Quantitative Strategy in Global Macro Research:

“Biotechnology and Internet stocks have seen their EV/Sales multiples triple and double, respectively, over the past two and a half years and they now make up a combined 8% of total US market cap. The median Biotech stock trades at 24x sales, nearly 10x that of the S&P 500 and the highest level since the Tech Bubble.

Meanwhile, the percentage of Biotech and Pharma stocks trading above 10x EV/Sales has reached about 60%. Strong performance, and high valuations, may be justified in some cases by improving pipelines and visibility, but the market has uniformly rewarded stocks in hot industries. The recent sell-off in high growth industries has been ETF driven, as mutual funds have actually been net buyers over the last several weeks. Given that Biotech and Internet carry 60% and 50% over weights in active managers’ portfolios, respectively; we may see more selling pressure in these pockets of the market.“

With valuations now being questioned combined with the extraction of liquidity this puts the markets at risk of further downside risk in the future. However, this DOES NOT mean that the markets are about to “crash.” However, a further decline in the future, particularly this summer, is indeed likely at this juncture.