Look out Below?

That may very well be what the markets are signaling.  We have seen higher close after higher close for weeks now that defies logic.  Fundamentals and technicals aside, the market will have to run out of breath at some point – I look at this market like a runner or biker that hasn’t paid enough attention to his nutrition or pace (read earnings and economic growth) and is coming to a point of exhaustion.  Once an athlete reaches that point in a race the resulting collapse is devastating.  We have seen television images of marathoners receiving IVs before the end of races.  Most have blamed the collapse on one of two things or a combination of both – my nutrition wasn’t correct or I simply started at an unsustainable pace.  Our trading and economic models suggest that is the point we are in this market cycle.  Two of our trading models and one economic model are confirming it’s time to get defensive.  Some of our defensive stop losses were triggered at the end of May and we have approximately half of clients in cash or bonds.  While I will be the first one to admit there is no perfect system or method for predicting market moves it is rare when we have three independent models confirming the same risk. 

Economic and trading models point to the most statistically significant possibility of a market movement.  It is no guarantee that movement will indeed prove out but rather the conditions exist for a significant movement.  We don’t tend to approximate how high or low markets may move but I have read estimates that vary greatly.   The Fed has announced that it is going to shrink its balance sheet.  Allow me to put that in layman’s terms.  Post financial crisis the Fed needed to put liquidity into our financial system to stabilize the economy and markets and spur growth.  The way it went about doing that was to buy bonds from institutions.  It is a simple transaction – the Fed receives a bond in exchange for cash.  That cash is now the liquidity you have heard so much about in the financial press for the past several years.  The Fed did this on a massive scale with the resulting in excess liquidity.  This is evidenced by the large cash balances on bank balance sheets all over the country.  The Fed had hoped all this cash would be deployed by institutions through loans or by investing.  Both actions result in the reflation of assets and higher prices.  Now the Fed is about to take the converse action by selling those bonds and taking cash for them.  That action will take liquidity out of the system.  In an environment where liquidity has been the primary driver rather than earnings the result is generally a market correction.  We follow market liquidity and have seen it decline over the past week already without the Fed action. 

We will need to see continued earnings growth in order for the markets to enjoy sustainable growth.  With our GDP hovering around 2% that is unlikely.  This is one time we would like to be wrong about our outlook because the result can be painful financial losses.  This is not a doom and gloom forecast calling for a market crash of any sort but rather a simple alert for clients about what they can expect to see.  We think the US is on a good albeit slow growth path.