The S&P500 dipped, finally, last week but only fractionally. Volume continues to be absent, making this dip in prices less meaningful. But volatility surged. The VIX index jumped almost 22%, suggesting that behind the scenes, traders are becoming worried about potentially larger price drops in the near future.
The macro news flow was light. Initial jobless claims was the strongest number of the week, coming in below 400,000 but still very much above levels associated with normal recoveries, especially recoveries three full years after the lowest point in a recession. International trade results disappointed; this means the US trade deficit was larger than expected and will hurt GDP growth in the first quarter. Also, consumer sentiment badly missed; instead of rising as expected, it fell.
Technically, the S&P is extremely stretched to the upside, in the near term. And last week’s price drop has done nothing to change this condition. Interestingly, stock prices are following a very similar path to the one we saw in early 2011–low volume melt-ups on declining volatility. And we all know what happened in 2011. Price rises hit a wall in March (with the Japanese earthquake) and then crashed in late July after the US federal debt crisis came to a head.
Will this year follow a similar pattern?
Well, while prices have methodically crept higher, we’re seeing several troubling signs developing behind the scenes.
One of the most important has to do with corporate earnings. The ratio of reduced estimates to boosted estimates for US firms is far higher today than in was this time last year. In fact, analyst downgrades are as high as they were in early 2008, and we all know what happened then.
Another troubling sign has to do with US gasoline usage. It’s been collapsing over the last 4-6 months, also at a rate that very closely mirrors the drop-off in usage in 2008.
With respect to international trade, the Baltic Dry Index has plunged to levels near or even below the lows reached in late 2008. This suggests that international trade is collapsing. Some of the decline comes from the jump in the supply of container ships, but this jump in supply did not all happen in the last three months, meaning that the bulk of this drop must me explained from a collapse in shipments.
In the US stock markets, a select few market “generals” have been disproportionately pushing up overall index prices. In the NASDAQ, for example, Apple’s rise has boosted the index tremendously. The same can be said for IBM in the Dow. These are not the types of market rises that normal bull markets are built on. When a very narrow sub-segment of the markets is responsible for most of the market advance, bad things often happen.
Finally, Europe is definitely in recession, no doubt about it. The only question is how badly will growth contract and how long will it last. In 2008, the US (whose economy is about the size of the EU’s economy) led the world into recession, even though optimists were holding out hope that the rest of the world would “decouple” and escape the US contraction. This time, as Europe contracts, and Japan and China slow, the market optimists are holding out hope that the US will “decouple” and escape the slowdown in the rest of the world. Will it happen? Nobody knows for sure, but history suggests that this is not a sure bet.
And the list of disturbing trends does not end here. But the US equity markets are ignoring these warning signs. Instead, they’re assuming that all will be well, that this time is different.
If so, then that’s good news, but the news is essentially already priced in, leaving limited upside in near term price appreciation.
If not, then that will be disastrously bad news, because this type downside is not priced in, which would lead US equity markets to correct significantly.