Crude Reality for Equity

Unsettling.  That’s probably the best way to describe today’s session if you’re an equity bull.  With the S&P 500 down more than 20 points on the day (-1.57%) and settlement near  the lows of the session, it seems clear that today’s downward bias may be more than a fleeting phenomenon.  Volume was average, so there’s no real indication of panic selling.  But when you consider that crude oil prices moved above $100/barrel again today and that numerous geopolitical issues remain unresolved, it makes sense that the equity market should back track a little.  And in many ways, today’s steady drift lower was merely a continuation of the selloff that began with the Egyptian unrest seen just over a week ago.  Gold prices also reflected this generally negative tone as bullion jumped over $23 to a new all-time closing high of $1,434.50/oz.  So despite some solid economic data today (manufacturing activity was up yet again), investors were simply unable to escape the broader concerns associated with higher energy prices and their ultimate impact on global economic performance.  As such, I view today’s move as confirmation of the fact that we are in the midst of a corrective phase in this equity market that will likely see the S&P 500 drop anywhere from 7 – 10% from its recent highs.  With the near-term price action in the gold, Treasury, and volatility index markets clearly confirming an improved demand for ‘safe haven’ assets, the ability to make a bullish case over the near term is getting tougher by the day and, therefore, warrants defensive posturing for the foreseeable future.  For reference, if the pullback proves to be consistent with my expectations, that would mean we could see the index move to the 1,200 level over the next month or two.

Clearly, I’ve been an equity skeptic for some time now, so it would be fair to say that I’m merely continuing my bearish mantra in an effort to eventually be proven correct.  That’s a fair criticism, I guess, but the fact remains that I have honestly disliked this equity market (on both an economic and valuation basis) for nearly six months.  And were it not for the monetary policy interventions of the Federal Reserve providing the justification for investors to buy shares during this time, I believe the negativity that we are beginning to see would have crept into the market much sooner.  In retrospect I should have followed the old Wall Street mantra of not ‘fighting the Fed’.  But the fact remains that most objective assessments of the domestic economy’s performance note the significant portion of economic growth that has been predicated on federal stimulus, both monetary as well as fiscal.  And with these ‘drivers’ coming to a deliberate end in the not-too-distant future, the realization that the U.S. economy will have to generate sustainable, self-derived growth amidst an environment of rising energy prices, constrictive Chinese monetary policies, and geopolitical unrest is finally beginning to hold in investors’ minds. 

To be fair, I am trying not to read too much into today’s price action since, as I’ve stated many times previous, one day does not a trend make.  But unlike previous periods when I noted similar mood swings in the market place, there appears to be no Federal Reserve stimulus plan at the ready to alleviate the growing mood of pessimism that appears to be taking hold.  In fact, reading between the lines of Federal Reserve Chairman Bernanke’s Congressional testimony, it seems clear that the increased threat of inflation (which is something the Fed has been deliberately attempting to orchestrate) coupled with an improved internal economic forecast for 2011 has largely negated any desire to add additional stimulus to the economy at this point.  To my mind, this opens the door for a more ‘normal’ ebb in the equity markets as the Fed put will be off the table for the time being.  To be sure, any sustained sell off of meaningful scale will get the chatter going fairly quickly, but, for now, a more fundamentally-based trade can take hold, which is something that really hasn’t been seen in six months (or three years for that matter).  And as I noted in last night’s post, valuations are stretched and primed for some sort of recalibration.

So If I’m correct that we are in the midst of a pull back, the question becomes one of next steps.  As you may recall, I’ve said that the continued strength of corporate earnings has compelled me to be a buyer on dips.  I am still firmly of that opinion, but with one major caveat.  China.  As noted previously, the reliance upon China and the Asian region for corporate earnings growth over the past few years has only increased.  This is part of the reason why earnings have been able to disconnect somewhat from the overall performance of the U.S. economy.  But with China grappling with internal strife (as always) and clearly attempting to stem the effects of commodity inflation through more constrictive monetary and banking policies, it seems evident that the earnings growth engine of the last decade may be primed for a slowdown.  This is why I’ll be weighing the relative health of the domestic economy with that of Asia when share prices near that 1,200 – 1,225 range.  But assuming no material change from the conditions we are seeing today, my bias will be to add equity exposure.  Granted, there’s a fair bit of ‘show me’ that’s going to have to materialize between then and now, but proof is all I’m asking for.

Looking to tomorrow, keep an eye on both crude oil and gold for signs of a continuation of the fear trade.  Also, as I Tweeted this morning, look to shares of Goldman Sachs (GS) for signs that the recent implication of a board member in the Galleon insider trading scandal is having a meaningful impact on share value.  With the SEC having stated previously that there would be a rash of ‘big name’ firms coming to light as a result of recent investigations, GS could prove to be the canary in the coal mine for the entire financial sector.  And as the last few years have proven, yet again, as go the financials so goes the markets.

Until tomorrow…..