One More Bounce? Maybe.

The S&P500 dipped another 0.2% last week, which was the fourth consecutive week of declines, even though each of these declines was very minor.  Volume was light, but some of that could be explained by the pre-holiday (Memorial Day), pre-summer drop off that’s very normal.  But volatility also dropped off, which suggests that complacency is still very widespread.

As discussed last week, the 2 year “recovery” could be nothing but a government (Fed and Treasury) engineered house of cards.  And this week’s data further supported this claim.  The Richmond Fed survey of economic activity plunged.  Durable goods orders collapsed; both the deadline figure and the ex-transportation figure were well below expectations.  First quarter GDP growth (annualized) was expected to be revised up from 1.8% to 2.1%.  Instead, it came in below expectations at 1.8%, or unchanged.  Initial jobless claims also disappointed; now they’re solidly in the 400 thousand range formerly associated with recessions.  And the stunner for the week was the Pending Home Sales index which fell by a whopping 11.6% (in April vs. March) and 26.5% year over year.  Because this is the spring selling season, it’s normally the strongest time of the year (for home sales).  Instead, sales are collapsing.  This begs the question:  if sales are so bad now, will utter disaster strike residential real estate in the late summer and fall?

The cyclical recovery, the house of cards, looks like it’s falling apart.

Technically, on the daily charts, the downtrend that began in the first week of May is still in effect.  But this is a gradual and low-conviction grind down in stock prices, not a violent downdraft.  The weekly charts are also showing (so far) a gradual erosion in prices.  The negative (or bearish) divergences on the daily and weekly charts are still very much intact.  The US stock markets are stretched in way they haven’t been stretched in a long time.

Could the stock market go higher?

Perhaps.  Actually, after the mild four week sell off, it would not surprise anyone if stock prices melted up in the first few weeks of June.

Why?  Mainly because the Fed’s QE2 pump has a few more weeks of pumping still left.

But such a bounce—even if it were to happen, which is by no means a certainty—will probably be short-lived.

First, a most important known known is fast approaching.  The Fed will shut off its QE pump.  Even a temporary shutdown ought to be enough to take some serious air out of the stock market balloon.  There is little doubt that this deflating moment will arrive and on firm schedule—by the end of June.

Second, the known unknowns are ticking time bombs waiting to go off. For example, the Greek debt tragedy is getting worse by the week. Default is almost 100% certain.  The timing is not—it could happen next week or early next year.  If it happens in June or July, then the Fed’s shut down of QE will only add to the market’s loss of confidence, or possibly panic.

Finally, there are the unknown unknowns.  So much of the global financial system’s asset valuations depend on an extremely fragile and interlocking set of equilibria.  Any one of a series of shocks—from energy, to climate, to geo-political, to food production and distribution, to environmental—are rocks that could break the financial glass house. The risks from these shocks are always present, but today’s exceptionally fragile financial state means that the impact from any one of these shocks would be exceptionally devastating.

There’s very little room for error in today’s stock market valuations. Sure, prices could slowly inch higher.  But they could also collapse in a heartbeat.

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