Gauging the Weakness

 | Aug 20, 2013 | 11:30 AM EDT
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This commentary originally appeared at 7:50 a.m. EDT on Aug. 19 on Real Money Pro -- for access to all of legendary hedge fund manager Doug Kass's strategies and commentaries, click here.

Was last week's market drop the real thing (a harbinger of a more significant market decline), or will it just be another nervous market breakdown (which will/should be bought)?

This is the important question that investors and traders are asking themselves this morning.

Risk Happens Fast

For nearly a month, the markets have appeared undecided, with mixed economic data, conflicting sector price action (and an apparent leadership change), steadily weakening market breadth and swiftly rising interest rates characterizing the market and economic landscape.

The one-month period appears to have been resolved to the downside on Thursday (a day in which the U.S. stock market gapped lower and closed near the day's low, all on heavy volume) and on Friday (a day in which the U.S. stock market closed on its low).

It's Different This Time

Last week, I outlined my expectations that the market had topped for the year.

I am sticking to that forecast.

The recent market swoon appears to be different than previous corrections, as measured by the eroding technicals, weakening fundamentals (and disappointing earnings) and wavering sentiment indicators.

Deteriorating Technicals

A bad technical sign was that, by the end of the week, the total NYSE new lows reached the highest level since June. Another profoundly negative signal was the bearish divergence between poor breadth and a market high in the weeks leading up to Thursday's schmeissing. Importantly, Thursday's down move looked like a breakaway gap (with only a limited attempt to reverse during the day), which historically signals an early/beginning trend vs. an exhaustion gap, which is more typically seen at the end of a move.

Weakening/Mixed Fundamentals

Away from a battery of deteriorating technicals, there have been developing core fundamental challenges that look different than in previous periods of market weakness.

Further pressuring and forming the likely catalyst for a drop in the market was a string of disappointing earnings from several high-profile companies, including Wal-Mart (WMT), Macy's (M), Cisco (CSCO), IBM (IBM), Google (GOOG) and Amazon (AMZN), among others. This is consistent with my theme that the consensus outlook for corporate profits remains too optimistic. (The cover story in Barron's agrees with my concerns.)

Economic data appear mixed. For example, unlike any time over the past 18 months, housing appears to be stalling, and so do the rate of growth in jobs and the improvement in retail sales appear to be slowing, while some of the manufacturing data have improved modestly.

In terms of the catalyst of liquidity, we are obviously closer to a tapering of quantitative easing and normalizing monetary policy than at any time during the corrections of the past two years. The uncertainty of who will be the next Fed chairman looms as a different headwind as well.

Dissimilar to previous corrections (since 2010), interest rates are climbing swiftly higher. The yield on five-year Treasury notes has more than doubled, and the yield on the 10-year U.S. note is moving to 2.85% from 1.35%.

Some Complacency Exists

Also different has been the absence of put buying last week, with the 10-day CBOE put/call ratio at a low 0.85 (similar to the level seen at the May 2013 top and compared with nearly 1.40 during the big weak day in June). Investor sentiment seems complacent, a likely outgrowth of a number of previous corrections that have proven to be buying opportunities.

What Are the Chances?

The factors above suggest that last week's market drop is different this time and that the market's drop is more than just another nervous breakdown.

This is in line with my view that the short-term top of two weeks ago represented something significant and that the market is doing more than just pausing/correcting in an extended cyclical bull market.

I would apply perhaps two-thirds probability that the year's high in the S&P 500 has been put in and that the current decline may be more significant than previous corrections. If this is the case, the first technical stop for the S&P 500 could be the June 2013 low (between 1550 and 1600), which would also coincide with the rising 200-day moving average and with a 38.2% (Elliott retracement). This would result in another 4%-5% decline in the market averages.

On the other hand, the possibility remains (let's give a 33% probability) that this is simply another correction that does no more than unravel an overbought market and is to be purchased. After all, in the most recent advance, almost every index (except the Nasdaq) rose to all-time highs.

Above all, as we begin to exit the earnings reporting period, we have to closely monitor the economic data. At the core of my topping thesis is that the public and private sectors' dependence on (and addiction to) low interest rates will be reflected in slowing global economic growth over the balance of 2013 and into 2014. This will likely weigh on corporate profits (estimates of which remain too optimistic).

Looking forward (and away from the fundamentals), rallies should also be assessed by observing the leadership, market breadth and investor sentiment, which are key determinants of if we can reach new bull market highs or if we experience a rally failure and put in a more meaningful top.

One of the most important keys that I will be looking at in order to determine this would be a more confirmed leadership shift (better relative and absolute strength) into economically sensitive industrial shares. If this occurred, it would be a market positive and would favor the notion that the recent market drop is but another correction in a bull market. If not, look out below!

I will be watching rallies.

So, too, watching market breadth will be significant in assessing the balance of the year. As well, investor sentiment as measured by the ratio of put/call buying and/or bullish and bearish sentiment (in surveys) should be assessed.

My base case is that, given the body of evidence today, a correction to the S&P 500 uptrend leg (1550-1600) that began in November 2012 is likely.

The Bottom Line

Much is different (read: worse) technically, fundamentally and sentimentally in the current market drop compared to prior corrections.

We will soon find out if this is another nervous breakdown or the start of something more significant.

It remains my view that the odds favor a greater correction than the many that have preceded last week's market swoon.

Regardless of one's outlook, we will soon discover the future course of Mr. Market.

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