The lagging S&P-500 finally closed at a new high at 1569.19 making it the last major index to exceed the 2007 highs.
The S&P had been stuck below the prior high of 1565.15 for two weeks with seven attempts to reach the high with no success. Hitting the goal on the last day of a record quarter may be too much good news for the market. Next week is going to be a pivotal week for traders. The records have been broken and the quarter is over. The end of quarter window dressing was instrumental is pushing the indexes higher and with the quarter over there may be window washing in April.
The Dow gained +11.25% in Q1 and that was the best first quarter since 1998. Had it closed +3 points higher it would have been the best gain since 1987. The Dow is now up for four consecutive months.
The S&P closed at 1569.19, which now becomes the new record closing high and the point from which Q2 will be measured. The prior intraday high was 1576.09 and we are still a few points away from that level. The S&P is now up for five consecutive months.
Even the Nasdaq managed to creep up to a new high at 3267.52. That is a 12-year high on the Nasdaq. It was last at this level in November 2000. The Nasdaq is now up five consecutive months.
The Dow Transports had a very strong quarter with a +17.9% gain but they closed at 6255.33 and just shy of their record high on Thursday. That high was 6,281 set on March 14th. That is close enough to be a winner as well.
The Russell 2000 Small Cap Index gained +12.03% for the quarter to close at 951.54 and just two points shy of its record close of 953.07 on March 14th. This was a very good quarter for small caps although the momentum did fade over the last two weeks.
Clearly the million dollar question is what to expect for Q2? If I knew beyond a shadow of a doubt I could charge readers $1,000 for this edition of the newsletter and everyone would be glad to pay it. Since nobody has a crystal ball we have to examine the various factors to determine a bias.
The first and most important factor is the Fed stimulus. There is a heated debate in the financial press over when the Fed is going to lighten up on QE purchases. This is driving me crazy since the Fed continues to say in its official statements and in the Bernanke speeches they will continue at the current rate until unemployment is 6.5% or inflation over 2.5%. Neither of those conditions is likely to be satisfied until 2014.
The various Fed speakers are not doing themselves any favors. Hardly a week goes by that someone does not mention the official targets but then suggests the $85 billion monthly rate may need to be adjusted up or down depending on how the economic situation evolves. They are shooting themselves in the foot by constantly injecting doubt into the market.
On Wednesday Boston Fed President Eric Rosengren said exactly that. "We should continue our large scale asset purchases through 2013 although the amount may need to be adjusted up or down depending on economics." It is strange that the financial reporters only seem to hear half of that statement. He said "up or down" but the reporters only seem to hear the down part and that is what gets repeated in the days that follow. Rosengren is currently a voting member of the FOMC.
Chicago Fed President Charles Evans told reporters, "This is a point when we have to be patient and let our policies work" with stimulus "firing on all cylinders." There was no mention of adjusting purchases downward. "I am going to have a lot more confidence if I begin to see indications that growth is well above trend and it is going to be sustainable. (emphasis mine) "We have gone through this type of thing before where we saw improvement in the labor numbers only to watch job growth slow to unhelpful levels."
Minneapolis Fed President Narayana Kocherlakota said "Monetary policy is currently nor accommodative enough." Kocherlakota said the Fed should lower the unemployment threshold to 5.5% instead of 6.5%. Kocherlakota is not currently a voting member.
Bernanke also added to the confusion last week when he said the Fed could alter buying patterns in response to improvement in the job market but he said further gains would be needed to confirm this was not a temporary improvement.
The majority of the Fed heads don't expect unemployment under 7% until 2014 as reported in their last update. Several outliers have skewed the average expectations to a range of 6.7% to 7.0% by the end of 2014. The estimates for the end of 2013 are 7.3% to 7.5%. Of course they are still expecting the 2013 GDP to be +3.0% and that is a moon shot from here. The Q4 GDP was just revised to a gain of +0.34% or one tenth of the Fed's estimate.
Only one of the Fed's 19 members expects interest rates to rise from 0.25% in 2013. Five of the 19 expect interest rate increases in 2014.
The comments from Rosengren, Evans and Kocherlakota on Wednesday helped to push out market expectations for no change in the QE plan until the end of 2013. Something will come along next week and mess with estimates again but that is what the market is seeing today.
With the Fed likely to continue the current QE program through the end of 2013 the equity market will continue to be supported. However, the market is a forward discounting mechanism. When the market begins to see evidence of a position change in future months the upward bias could evaporate.
The challenge for the markets is the unwinding of the Fed's balance sheet. The change in the amount of the monthly QE purchases will probably not be material to the market since there is already a lower beta from the fourth QE program since the recession. Each of the recent QE programs have had a smaller impact than the prior ones. The actual real impact to the market would be the big impact to sentiment. That sentiment is a major part of the Fed's hold on the market. The reason sentiment will change dramatically is the Fed's history in unwinding stimulus. They have NEVER been successful in unwinding stimulus without a major impact to the markets and the economy. That statistic is critical since the Fed has NEVER had this much stimulus in the market. By the end of 2013 the Fed's balance sheet will be $4 trillion.
When Bernanke was asked how the Fed would unwind this QE he said the Fed could just let it run off to maturity and not impact the market by selling the securities. That is total BS and spoken to try and manage expectations. The money is in the market. If the economy begins to accelerate the Fed will have to extract the money in order to avoid inflation. With a balance sheet full of long dated securities today they can't wait 10-15 years for those securities to mature. When inflation begins they will need to move quickly and it will be ugly.
So, it is not the end of QE the market fears but the turning point in the QE process. The Fed could end QE and do nothing on rates for months to come if the economy continues to be sluggish. Once a sustainable recovery begins the Fed will become the number one priority for market watchers.
For the purpose of our short term outlook today the Fed's position is supportive of a continued rally in equities and rebound in housing. That is not likely to change over the next three months.
On a side note the Fed may continue QE longer than expected because of the impact on the Federal deficit. Once interest rates begin to rise the deficit is going to rocket higher. With Fed funds rates at 0.25% today the government is able to finance 46 cents of every dollar it spends by selling treasuries at ridiculously low interest. For every 1% increase in the interest rate the annual interest payments on the Federal debt rises by $170 billion a year. At a normal interest rate of 5% that is an increase of $765 billion a year in interest. The government only takes in $2.7 trillion in taxes and currently spends $3.6 trillion for a deficit this year of $900 billion. If you increase the annual interest payments by $765 billion that is a direct increase to the deficit of $765 billion in addition to the -$900 billion in current deficit spending. The result would see the deficit almost double. The debt would almost immediately become unsustainable and be followed by insolvency by the end of the decade.
We are living on borrowed time that has been funded by the Fed's purchase of $3.4 trillion in securities. When QE ends and they are no longer purchasing the majority of the government's new debt the rate of interest the market will demand is going to rise dramatically. The rapidly rising interest rates are going to crush the economy. Bernanke knows this and I am sure this will be a factor in how long the QE remains. The Fed is between a rock and the proverbial hard place. There is no way out of this trap but the equity markets remain blissfully ignorant. Fortunately that is not a problem we are going to face in the next quarter.
The next market hurdle will be earnings. The S&P 500 is expected to grow earnings by +0.58% for Q1. That is a very low bar and should easily be beaten but will the bulls keep buying stocks if earnings turn negative? That is a big question mark and it will probably be a cloud over the market until we get the first dozen or so reports for Q1.
For Q1 we have seen 86 S&P-500 companies issue negative guidance and 24 issue positive guidance. That means 78% of companies issuing guidance have issued negative guidance. That is the highest percentage of negative guidance since FactSet began tracking guidance data in 2006.
Red Bars = Negative Guidance, Green Bars = Positive Guidance
Meanwhile analysts are still expecting double digit earnings growth for Q3 and Q4 but the fundamentals behind those estimates are very fragile. If we see a negative Q1 the estimates for the rest of the year are going to decline as well. That will impact S&P forecasts and the house of cards could come tumbling down.
However, there is nothing in the pipeline other than the deepening recession in Europe and the rising dollar to impact those earnings estimates. Corporations are in bunker mode and still making their earnings using cost reductions. Revenue has been flat to slightly down. The QE economy is not growing at a rapid pace. Only the equity markets are growing.
The final Q4 GDP update on Thursday was revised higher from 0.13% growth to 0.38%. Hold your applause please. I know you can hardly contain your excitement. That is the slowest growth since 2011-Q1. Analysts claim the Q4 GDP benefitted from tens of billions in accelerated dividends that were pulled into Q4 from Q1 and a flurry of special dividends ahead of the potential tax hikes in the fiscal cliff. That huge increase in dividends prompted a jump in consumer spending and personal income. The savings rate rose to 4.7%. Inventory accumulation collapsed ahead of the cliff and knocked -1.5 points off the headline number. Exports fell due to the rising dollar and reduced GDP by another half point. The uncertainty over the Fiscal Cliff caused a halt in business spending.
The first look at the Q1 GDP is not until April 26th and the consensus estimate is for +2.8% growth. However, with the sequestration debate in Jan/Feb picking up where the Fiscal Cliff debate ended we could see continued economic paralysis. Once the sequestration took effect on March 1st government spending dropped sharply. Some government spending had declined earlier in the year since the government spends now and pays later. The spending was cut early in anticipation of having no funds after March 1st. This is going to be a tough quarter with the consumer spending having been pulled into Q4 by the accelerated dividend payments.
Other GDP estimates include Merrill Lynch +3.0%, Goldman Sachs +3.4%, Macro Advisers +3.5% and Nomura Securities +2.5%.
The Kansas Fed Manufacturing Survey rose slightly but remained in contraction territory for the sixth consecutive month at -5. This was an improvement over February's -10 reading but still the second lowest reading in six months. New orders rose from a horrible -25 to zero for March. Backorders rose slightly from -18 to -16. The worst component was a sharp drop in employment from +2 to -15 and back to the financial panic levels of 2008. The manufacturing trends in the Kansas region have been worsening for the last year.
Kansas Fed Chart
After a two-month bounce the Chicago ISM fell -4.4 points from 56.8 to 52.4 compared to analyst expectations for a rise to 57.1. New orders plunged from 60.2 to 53.0. Backorders fell from 50.9 into contraction territory at 45.0. Employment slipped slightly from 55.7 to 55.1. The production sub index fell to 51.8 and posted its weakest number since September 2009.
Chicago ISM Chart
Jobless Claims rose to 357,000 from 341,000 the prior week. This is the highest level in five weeks and the second weekly gain. It is the first time over 350,000 since mid February.
Consumer Sentiment on Friday was a shocker. The final reading for March spiked from 71.8 in the first half of the month to 78.6. Analysts were expecting a continued decline. Analysts believe the stock market hitting new highs over the last two weeks of March plus declining gasoline prices and the arrival of spring weather in the South were contributing factors. Let's see if it holds up for April.
Consumer Sentiment Chart
Next week is a big week for economics. We have three ISM reports and three payroll reports. The ISM reports for March are expected to decline slightly to correspond with the declines in the regional Fed reports. As long as the declines are minor they should not impact the market.
The Nonfarm Payrolls on Friday could be a market moving event. Expectations are for a decline to 190,000 after a +236,000 gain last month. There are estimates as low as +135,000 and that would be market negative. Another gain over 200,000 could also be negative if it is accompanied by another decline in the unemployment rate. That would create more worries over a quick end to QE. Most analysts believe we will remain in the 150,000-175,000 range for the next quarter as a result of the sequestration process. This would probably result in the unemployment rate rising slightly over the summer.
On Thursday we will get the rate decisions from the ECB and Bank of England. We will also find out if the Bank of Japan is going to launch an aggressive QE program to back up their tough talk over the last two months.
The economic update would not be complete without reporting that the number of people receiving food stamps rose to the most ever at 47.8 million according to the Agricultural Department. That is 15% of the population and 70% more than in 2008 during the recession. The program cost the taxpayers $74.6 billion in 2012. That was double the cost of the program in 2008. How strong is the economy when nearly 48 million people are on food stamps and the number is surging every month?
Also weighing on our markets in Q2 will be the deepening recession in Europe. The Cyprus bank robbery will weigh on all the southern countries with weak banks. The IMF said the GDP of Cyprus would decline by 20% as a result. The bank worries will migrate to Spain, Italy, Ireland, Portugal and Greece and cause a drain of deposits on those banks. The hoarding of cash will depress consumer spending and deepen the recession. The EU debt crisis is coming back. We can count on it.
The estimates for Eurozone GDP continue to fall and this has not yet taken into account the hit to the zone economy from the Cyprus bank robbery. Europe is China's biggest customer for manufactured goods. This suggests China is going to slip back into a decline towards 7% GDP. Markit said "France has overtaken Italy as having the worst performing retail sector of the three largest euro area economies. Sales fell at a record pace as did employment. Italy posted another steep decline and German sales were flat."
Euro GDP Predictions
Cyprus banks reopened on Thursday with a 300 euro withdrawal limit. Check cashing was restricted. Nobody was allowed to close an interesting bearing time deposit like a CD. There is a limit of 5,000 euros per month on transfers out of Cyprus. People traveling out of Cyprus can't take more than 1,000 euros in cash. Credit card charges were limited to 5,000 euros a month. The finance minister said the restrictions could be lifted in a month. That is far longer than the initial claims of 4-7 days when the restrictions were announced. In a similar situation in Argentina the restrictions lasted more than a year. Citizens in other EU countries are watching this carefully and planning their future banking strategy. Mario Draghi and the ECB are meeting next week and you can bet there will be a long list of weak banks on the agenda. Since the EU forced a 70% haircut on Greek debt there are hundreds of undercapitalized banks in the EU.
Smart money is going to flee the eurozone. Spain has already proposed a 0.2% tax on deposits to aid its stricken banking system. That is the camel's nose under the tent. If they get the small tax passed they will come back to the well for bigger numbers in the not too distant future. Italian depositors are now targets of a proposed 15% tax plus a one-time property tax. All of these well intentioned efforts to prop up the banking systems are only going to hasten their decline as money leaves the eurozone and heads to places like the USA. This will serve to further weaken the eurozone banks and require higher deposit taxes and more bailouts.
Treasuries have suddenly come back into favor in the USA. We are the cleanest shirt in the dirty close hamper and a safe haven for European cash. The yield on the ten-year treasury fell to 1.85% and right at a six-week low. The big increase in bond buying at the same time equities are breaking out to new highs suggests there are some underlying worries in the market along with that influx of cash from Europe.
Ten Year Treasury Yield Chart
We had a great year in Q1. Fortunately, if historical trends continue we should finish even higher in Q4. Unfortunately, there are a lot of trading days between now and year end. Of the 12 years since 1950 that the Dow gained more than 8% in Q1 only two of them closed lower in Q4.
Dow Gain Table for Q1 Over 8%
New highs tend to produce more new highs. Sentiment at market highs tends to be infectious. We have watched investors buy the dips since November and every dip is bought earlier than the one before it. The dips are shallower and shorter. This has allowed the rally to continue while there has been rotation from sector to sector.
April is typically the best month of the year for the Dow. However, the first two weeks are normally down and the last two weeks are up. The decline in the first two weeks is related to a pause to reload from Q1 gains and some profit taking ahead of Q1 earnings. Investors with sizeable profits don't want to risk those profits on an earnings miss. The last two weeks of April are typically up because earnings are flowing fast and traders get caught up in the earnings cycle when it is positive.
That trend fades into May when the "sell in May and go away" cycle takes over. The Stock Trader's Almanac made this cycle famous after they pointed out that owning stocks over the May-October period generated negative returns since 1950 while buying in October and selling in May produced outsized profits far in excess of simply buying and holding stocks year round. The summer doldrums tend to suck the life out of stocks as weak Q2 earnings depress prices. The Almanac claims the Dow has risen an average of +7.5% during the best six month period and only +0.3% in the worst six months since 1950.
Proving that historical trends are fallible the first quarter after a presidential election is typically the worst quarter of the four year election cycle. I am sure glad I was not betting on that trend this year.
Stock Traders Almanac Historical Performance by Month
Thomas Bulkowski (Encyclopedia of Chart Patterns) studied the seasonality patterns over his 30+ years of trading and determined that March was the best month to sell stocks and May was the worst month of the year to buy stocks. September was the best month to buy and August the worst month to sell. April was neutral with gains and losses almost even over the 30+ years. The gains made in January-May were three times the amount of those made during June-December.
A study done in 2008 by Stephen Ciccone and Ahmad Etebari found that since 1929 a dollar invested in May through October grew to only $6.42 while the same dollar invested November through April grew to $3,892.
As I have said many times in the past "history is a guide not gospel." In theory we should be expecting the current rally to slow over the next two weeks, rebound in the last two weeks of April and then decline into summer. As Yogi Berra once said, "Theory never works in practice."
The market will make fools out of the most people possible at any given time. If the majority of analysts are calling for a correction it will never come. If those same analysts were calling for a continued rally we would see a correction instead.
The last time the market was as overbought as we are today was in October 2007, which just happens to be the prior market highs. The percentage of S&P-500 stocks over their 200 day average is 89.8% as of Friday's close. However, that is a long term average and after a four year rally most stocks should be over the 200-day. That is up from less than 50% in November.
SPX Percentage of Stocks over 200-Day Average
If we step down to a shorter average like the 50-day the percentage is still high at 79.8% but lower than the 94% in January. As recently as November when this last rally began the number was 23%.
SPX Percentage of Stocks over 50-Day Average
The point here is that the market is overbought. The goal was achieved at the close on Friday. If the market was a marathon runner it would be the equivalent of stumbling across the finish line gasping for breath. The S&P tried to reach the highs seven times over the last three weeks and came within five points without closing the deal. Using its last ounce of strength it managed to cross the finish line on Friday.
We should see the market catch its breath next week with some minor consolidation and then mount another charge towards new highs. I believe we buy the dip and stay with the trend as long as it continues. We need to be ready to bail if the earnings turn negative or when we reach May.
It is unimaginable that the market will just continue moving higher. However, stranger things have happened. New highs beget new highs. European money will be headed our direction to escape the next version of the EU stability tax. IF the S&P was able to tack on another percent or two the bears would be forced to throw in the towel and chase the market higher. That is a BIG IF.
The S&P broke out to a new historic high by +4 points. The odds of at least a minor pullback early next week are about 100% but the dip should be bought. In order for the rally to continue into the earnings cycle we need the S&P to extend its breakout and show some strength over that 1565 level. Once traders give up on the idea of a failure at this level the naysayers should diminish and the rally continue.
S&P chart - Daily
S&P Chart - Weekly
The Dow extended its closing high record by +19 points to close at 14,578.54. Adding +19 points every other day is like watching grass grow and the bears have got to be having a fit. This kind of slow melt up with intraday declines looks a lot like a failure during the decline and the shorts pile on only to be forced to cover at the close. The market just keeps getting base hits and no home runs. Fortunately they all count.
For an index of 14,500 points a +19 point gain is not relative except that it was another record close. Since the 14,382 intraday low on the 19th we have a nice pattern of higher lows on every dip.
The window dressing was successful and all the funds get to play up the record closes in their quarterly statements. However, this is window washing week and all those stocks that were marked up last week could see money flowing back out to replenish the discretionary coffers. Managers were pretty close to fully invested last week and they need cash to handle normal redemptions so expect some minor selling.
Dow Chart - Daily
It was a miracle the Nasdaq closed at a new 12 year high. Apple has been in crash mode the last two days losing -$21 in the process. Interviews with Foxcon workers in China found they had nothing to do. There are no orders and very few products are being manufactured. Apple shares will likely return to $420 unless there are some positive revelations in the days ahead. Apple is not innovating fast enough or with enough products to keep up with the tsunami of new products from Samsung, LG and Motorola.
The Nasdaq managed to creep over the prior high of 3258 set back on the 14th of March to close at 3267.52. Like the Dow it has been putting in higher lows since the 19th and finally overcame the Apple drag on Friday to post an +11 point gain. Like the Dow and S&P the minor new high is probably going to be tested early in the week as funds take some profits. Strong support at 3200 is likely to hold.
The Russell 2000 Small Cap Index could be the canary in the coal mine. The Russell did not make a new high and was barely positive on Friday. Window dressers were able to keep it pinned at the high end of the range for the last two weeks but could not push it higher. Support at 938 is now critical. If that level breaks we could easily see a drop to 895 but it would take a serious change in market sentiment. I am sure we would have several dips bought along the way.
Watch the Russell as the market sentiment indicator this week.
I think it is pretty safe to expect at least a modest dip next week. How much of a dip depends on the news from Europe and the economic reports. The marathon market just crossed the finish line and the legs are going to be a little wobbly.
Once past this week we should have a better idea about what to expect for the rest of April but May remains a solid risk for the Q1 gains. That will be especially true if we continue to get earnings warnings at the rate of 3:1 over positive guidance.
Enter passively and exit aggressively!
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"There are two ways to conquer and enslave a nation. One is by the sword. The other is by debt."