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We Are Approaching The Moment When Markets Will Be Driven Again By Fundamentals

Tuesday, 08 April 2014 02:04 PM Current | Bio | Archive

After the Nasdaq saw its worst three-day decline since November 2011, and which was certainly not related to quantitative easing (QE), it's not surprising that now some start to think this could be the beginning of that long-awaited correction, which is a downward move of 10 percent or more.

Who knows, this three-day decline probably signifies nothing at all, but it also cannot be discarded as the first significant appearance of a rare "crack" in the practically relentless and widespread optimistic mood that has driven U.S. stock market prices up since the Great Recession ended.

By the way, a market becomes a bear market once the decline is more than 20 percent. To refresh your memories, the S&P 500 has experienced 12 bear markets since World War II.

Markets are incredibly difficult to predict, but it would be good to remember that the S&P 500 has seen seven of its bear markets run their courses in U.S. mid-term election years. These years were 1962, with a -28 percent decline; 1966, with a -22 percent decline; 1970, with a -36 percent decline; 1974, with a -48 percent decline; 1982, with a -27 percent decline; 1990, with a -20 percent decline; and 2002, with a -49 percent decline.

Since 1962, the S&P 500 has experienced a correction of at least 14 percent in 10 of 13 mid-term election years, while in the other three years, the corrections ranged between 8 and 9 percent.

No, these facts by themselves don't mean we will experience this year another correction of 10 percent or more, let alone see the start of a bear market of a 20 percent decline or more that usually develops within a four-year time frame, but they can't be totally ruled out either.

Finally it's certainly solid food for thought that in the last 13 U.S. mid-term election years, bear markets began or were in progress nine times. Of course, as we all know, past performance doesn't guarantee future results.

I have no doubt whatsoever that the stock market's next long-term wave will be down. As for yields on the 10-year U.S. Treasury, I certainly still don't exclude first a new move down in yields (which means higher bond prices) to the 2.35-2.45 percent zone or even lower before the yields should restart their long-term rise again that could carry them up substantially beyond the 3 percent yield zone before 2015 is over. If that occurs, it could pose serious headaches to various emerging economies. However, China, together with other far eastern Asian emerging economies, could be part of the exceptions among the emerging economies, because a substantial rise in U.S. yields would translate into a stronger dollar, which would help all their exports.

For now, it looks like the dollar will continue bottoming out, but long-term investors should watch its performance against the Swiss franc, because once the dollar breaks out against the Swiss currency, it might be the signal of the start of a long wave up of a strengthening dollar.

Apart from all that, when commenting Monday on what's going on in and around Ukraine ,the U.S. ambassador to the Organization for Security and Co-operation in Europe, which is the world's largest security-oriented intergovernmental organization stated: "We have strong evidence that there are tens of thousands of [Russian] forces on the border and again not in their normal peacetime positions or garrisons." At the same time we see renewed unrest in the Ukraine's eastern provinces. For any investor all that is related to the Ukraine should be of real concern.

To me it's really interesting to see how the euro seems, at least at first view, to be immune to 1) the real and still growing risks that represent the Ukraine to the European Union in the first place, 2) talks at the European Central Bank (ECB) of implementing an EU "variant" of quantitative easing (QE) and 3) ECB President Mario Draghi's recent warning about the single currency's strength. When we look a little bit deeper, we see the main reason is the still-ongoing mania of "reaching for yield" even at the cost of taking on illogical risks. That in fact continues to support the euro's strength.

It's even more mindboggling to see (sorry this is somewhat technical but important enough to mention) the euro/dollar three-month at-the-money-forward implied volatility now stands at 6.08 percent after having dropped 70 basis points in only 10 days, which is its lowest closing percentage since August 2007. Yes you read well. That implies the euro should now experience its quietest three-month period since its inception now more than 10 years ago.

To me, that's an astonishing exhibition of bubble-like behavior. I don't know how long that can go on, but I do know this bubble will also, like all the others we have experienced before, burst one day. Don't ask me when it will burst, but I still expect the euro to be around the $1.20 handle within the next 12 months.

Coming back for a moment to the U.S. employment situation data that were released on Friday, while the unemployment rate remained stable at 6.7 percent, the data now also 1) show spare capacity is coming down thanks to a rising participation rate and 2) indicate support for household cash flow rising thanks to hours worked and employment levels. All this reinforces, at least for the time being, the idea of a recovery without changing the Federal Reserve's policy position.

That said, while the number of civilians unemployed for 27 weeks or longer as communicated by the St. Louis Fed came down by 110,000 units since February, the total number still stands at a stunning 3.7 million, compared with the 1.3 million long-term unemployed in December 2007 when the Great Recession officially started.

To me, this remains one of the troubling and lingering signs that show the recovery is far from complete. The big question is what the Fed can do about it now that it becomes clearer by the day that QE only achieved part, albeit an important part, of the job of eliminating/finding a solution for the long-term unemployed. I'm afraid the Fed has done all that was in its power and it's now up to the policymakers in Washington to do their job.

Besides, it's an undeniable fact that the accommodative measures of the Fed prevented a collapse of the U.S. economy while at the same time it helped at an unprecedented scale those, which certainly are not what we could call the savers of Main Street, who have been able to trade the upward channel of rising stock prices since the Great Recession ended. Okay, so be it.

But no doubt that won't go on forever and I wouldn't discard what Fed Chairman Ben Bernanke said in mid-May of 2013: "In light of the current low interest-rate environment, we are watching particularly closely for instances of 'reaching for yield' and other forms of excessive risk taking, which may affect asset prices and their relationships with fundamentals."

Yes, it could be we are approaching that moment when markets will be driven again by fundamentals, which is certainly not the case today and which is in no way reflected in today's market prices.

By the way, the Organization for Economic Co-operation and Development's composite leading indicators shows growth in the United States remains around trend.

So, we'll see what happens when the markets finally come back to earth.

Yes, what goes up must come down.

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After the Nasdaq saw its worst three-day decline since November 2011, it's not surprising that now some start to think this could be the beginning of that long-awaited correction, which is a downward move of 10 percent or more.
Tuesday, 08 April 2014 02:04 PM
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