Subsurface Weakness

 | Apr 03, 2013 | 12:00 PM EDT  | Comments
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This commentary originally appeared at 8:42 a.m. EDT on April 3 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

"If there was ever a misleading day, this [Tuesday, April 2, 2013] was it."

-- Dan Greenhaus, BTIG

Since I have been away over the past two days, the S&P 500 has risen by only about 2 points.

Nevertheless, some subsurface weakness and emerging divergences have been developing, a thinning out that has historically presaged broader declines:

  • The Russell 2000 underperformed on Monday (-1.3%) and was down (-0.5%) on an up day on Tuesday.
  • The advance/decline line is eroding as the market's rise narrows.
  • Breadth disappointed – yesterday, NYSE decliners eclipsed advancing issues by over 200, excluding ETFs and fixed-income closed-end funds.
  • The number of new 52-week highs narrowing.
  • The bank stocks/brokerages are lagging.
  • Transports trailed, down 1.5% and 1.2% on the first two days of the week, respectively -- check out the chart of FedEx (FDX).
  • Semis got schmeissed (-2.0% on Monday and -0.8% on Tuesday).
  • The cyclical index dropped by -0.7% on Tuesday, following a 1.2% decline on Monday -- check out the chart of Caterpillar (CAT).
  • The yield on the 10-year U.S. note remains low (1.86%) and is signaling slowing domestic economic growth -- speaking of the bond market, this week brought a continued disconnect between Treasury note and bond yields (lower by 3 to 4 basis points) compared to the market averages (slightly higher in price).
    10-Year Treasury Note vs. S&P 500
    Source: Bloomberg

On the other hand, the consumer nondurables/staples sector has been on fire, with continued gains in the share prices of Procter & Gamble (PG), Colgate-Palmolive (CL), Clorox (CLX), General Mills (GIS), Coca-Cola (KO), PepsiCo (PEP) and the like, and so has the traditionally defensive health care group.

It is an unusual market feature when defensive stocks are among the leading groups in a market moving to new highs.

Global Economic Growth Is Slowing

Besides the aforementioned weakness in market breadth and divergences, this week has brought additional and continuing signs of slowing domestic economic growth.

Some of the data suggest that my estimate of first-quarter 2013 real GDP growth of +2.75% to +3.25% -- most Wall Street firms are at +3.25% to +3.50% -- may be unsustainable over the balance of the year.

March ISM (at 51.3 vs. expectations of 54.0 and February at 54.2) was well below expectations, as the January-February inventory rebuild appears to have been nearly completed, leading to a moderation in manufacturing activity in the last four weeks of the quarter. New orders were especially poor, falling below the six-month average.

U.S. bond yields continue to slip (now at 1.86%).

Citigroup's U.S. Economic Surprise Index has recently fallen to a four-week low, and the non-U.S. surprise indices are all also moving down. (Note: Worsening economic trends have resulted in my paring back, once again, of my short bond position, as I continue to try to position myself for the best possible entry point for a long-term play in the asset class.)

After the close on Tuesday, March (SAAR) automobile sales came in at 15.22 million units, slightly less than expectations of 15.32 million and below February's print of 15.3 million. March's deliveries were the weakest since October 2012 and have more or less flat-lined since November's nice increase -- and so have the shares of Ford (F) and General Motors (GM) been virtually unchanged over the last three months.

Over there, the southern area of the eurozone is in an economic death spiral. France's economy is imploding, and its government seems even more dysfunctional than ours. Also, many of us don't know what to believe about China's economic data, which seems to be disconnected with on-the-ground data. (Note: The HSBC Services PMI climbed to 54.3 in March , up from February's 52.1 and the highest since September.)

Finally, Goldman Sachs' final March GLI now places the global industrial cycle in a "slowdown phase," characterized by still-positive but declining momentum.

From Hero to Goat

There is little question that investors are feeling the pressure of underperformance. Hedge funds are now at their highest net long exposure in some time, sentiment studies are uniformly bullish, and retail investors are warming up to stocks.

For those who are of the view that the U.S. stock market feels like it will never decline (and that global easing is the panacea for growth and ever-rising share prices), we suggest you look at the price of gold in mid-September 2011 and/or the price of Apple's (AAPL) shares in late-September 2012. At those points in time, investor sentiment was at an extreme. Now look at the subsequent price drops following those heights and where those prices stand today.

Many are certain of a continued market climb into 2014. Unfortunately, the only thing I remain certain of is the lack of certainty and that some of the conditions described above are consistent with classic top signs over stock market history.

In Bernanke We Trust

The lift in the S&P 500 in first quarter 2013 was clearly a reflection of the better-than-expected real GDP growth, abetted by broad-based central bank easing. Of course, massive monetary intervention has been the primary difference between March 2013 and other periods. At least domestically, however, I view the marginal impact of quantitative easing as not trickling down into the real economy, though it has clearly buoyed equities and fixed-income securities. And I strongly view global growth dependent on central bank easing (which still appears not to be self-sustaining) as an inherently low-quality state, deserving a less robust valuation than accorded in prior periods. (First-quarter 2013 real GDP of nearly +3% should decelerate to gains of +1.5% to +2.0% in the last three quarters of the year.)

The Crowd Continues to Outsmart the Remnants

To be sure, the naysayers (such as myself) have been vilified, and any further top talk has now become almost indistinguishable from "The Boy Who Cried Wolf," as the averages have powered higher and have resisted crisis after crisis.

This morning's opening observations do not guarantee a top -- indeed, the recent internal divergences could be remedied and reversed. The technicals could improve, as they have at numerous stages of the current rally.

They do, however, point to current conditions that in the past have indicated a top.

Summary

Mr. Market's recent move higher has been unbalanced (measured by breadth and sector outperformance/underperformance), as it has been led by nearly parabolic moves in consumer staples and health care stocks, while the optimistic forecasts of accelerating and self-sustaining economic growth are not being validated by the lagging smaller-caps, industrials, technology and other economically sensitive sectors.

Citigroup's surprise indices for the U.S., Europe and the emerging market economies are all weakening -- in the EU and in emerging markets, the surprise indices have actually turned negative.

A slowing in global GDP after a strong first quarter (importantly buoyed by inventory replenishment after a fourth-quarter 2012 inventory contraction) will likely define worldwide economic growth over the balance of the year.

To the extent that the outsized first-quarter 2013 stock market gains were a product of better-than-expected growth, the next few months of market returns could be adversely impacted by less-than-expected growth in the real economy and in corporate profits.

As well, a stronger U.S. dollar coupled with slowing global growth should pose a challenge to optimistic consensus earnings expectations for 2013.

Other meaningful non-confirming technical divergences (discussed earlier) are increasingly conspicuous.

My personal experience is that when I have found myself as frustrated as I am these days, the best thing to do is to take a few deep breaths, reassess one's analysis/conclusions and if proven to still be in place, ignore the cheerleading and uninterrupted price rise.

Every subscriber must develop his/her own view of the market's risk/reward as well as that of individual stocks, with time frames and risk tolerance being the most important ingredients to that decision.

Unless the economy accelerates from first-quarter 2013 growth and/or central banks become even easier than is generally expected -- I expect neither of these developments -- it remains my view that the market's risk/reward ratio remains resoundingly unfavorable, and few individual longs meet my buy criteria.

I am sticking with my analysis and investment process, and I am battening down the (investment) hatches.

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