Okay, I will fully admit that so far this year, I have been wrong regarding the markets. I have been expecting a correction for several months – since February – and the market has continued to drive to new highs, with only a few minor pull-backs. One could argue that if I just keep calling for a correction, eventually I will be right. I would agree with that in principle, but that is an oversimplification and is certainly not my strategy or my reasoning for continuing to call for a correction. However, the simple truth is that the higher the market goes, the more vulnerable it is to a correction. Any relatively small economic misstep could be the trigger that initiates a correction.
The key differences with the current rally are significant, when compared with all other major bull market rallies of the past. First, on a sector basis, it is the defensive sectors, such as Healthcare, utilities, and consumer staples that are driving the market higher, and not the high growth sectors such as commodities and technology that we would expect to see in the lead. This is obviously concerning, since market leadership should come from growth-oriented sectors during an economic expansion. One could argue that the fact that the growth sectors have lagged just means that there is more room for the market to rally if those sectors play catch-up.
The next major difference, and this is at the root of the current rally and more specifically why the rally has continued well beyond where it should have or where I thought it would go, is the Fed’s stimulus operations – QE 3. The Fed has continued to purchase $85 billion in long-term bonds every month and doesn’t seem concerned about the possible negative impact on the value of the dollar, inflation, disruptions in financial markets globally, the inflated value of the stock market, or any other negative side effects. Historically the Fed’s mandate is stable employment and economic growth, but it seems they have now shifted to driving stock market returns.
I did not fully grasp the massive overriding impact of the Fed action for the stock market, instead believing that investors would focus on revenues, earnings, and valuations. As with all anomalies in the financial markets, at some point there will be a reversion to the mean, or in layman’s terms, a return to the norm. These days we tend to get large overreactions on the upside and the downside, with the magnitude of the overreaction directly proportional to the gap between the normal and the anomaly, or to put it simply, the further out of whack the market gets, the further it will have to fall and the further it will move beyond fair value on the downside.
The Fed, at some point relatively soon, will be forced to stop printing money to buy down interest rates. The first time they signal a start to the end of QE3 we could see the stock market read this as the trigger for a correction (if the correction hasn’t already started by that point). The old adage – don’t fight the tape is certainly ringing in my ears every day. There is no way to know how high the markets will push before they loose steam and correct. My feeling is that we will have a relatively benign report of some economic data-point, or a political issue will arise that on the surface seems minor, but which will trigger a 5% or larger single day drop in stocks. This will likely be followed by an attempt to buy the market back up that will fail. During the following few days, stocks will sell-off by several more percentage points, at which time the media will jump all over the story, proclaiming this to be the beginning of a major correction. The downward move will gain momentum as investors scramble to get out before losing all of the their paper profits and some of their principal. This momentum should drive the markets down significantly, with the magnitude of the correction a function of how high the markets have pushed before the correction starts.
Of course I could be wrong and the market could just keep going up forever, but that isn’t very realistic. There are always corrections, especially when markets get extended as they are today. The only question is; when and by how much will the market correct?