Crash, Down Quarter, Major Correction—It’s All in the Cards

Crash, Down Quarter, Major Correction—It’s All in the Cards image 130613 PC clarkCrash, Down Quarter, Major Correction—It’s All in the CardsThe appetite that institutional investors have had to bid the stock market is diminishing.

Earnings estimates for the second quarter are actually being trimmed by corporations and Wall Street. It makes for a genuinely peculiar environment for the stock market—share prices at their highs on declining expectations for corporate earnings.

The lesson is clear: it doesn’t pay to fight the Fed.

Being a leading indicator, the stock market went up after employment numbers came in just slightly below consensus last week. Share prices going up on bad or weaker-than-expected economic news is powerful.

This has been going on for a number of months now. Even on days when equities open lower based on weak economic data or on technical metrics, the market has often fought its way back up.

The powerful stock market action since the beginning of the year has been a combination of renewed confidence, relative monetary certainty, the slow investment of new cash inflows, and good corporate health (strong balance sheets and solid earnings maintenance). (See “Stock Market Fake-Out: Where Is the Retrenchment?”)

But with the stock market now gyrating on the end of quantitative easing, it is distracted until second-quarter earnings season begins.

A massive stock market pullback is due anytime. Expect it. Be prepared for it. Equities have been due for a significant retrenchment for months.

The fact that stocks didn’t sell off during first-quarter earnings season really surprised me. It increases the likelihood that institutional investors will use this as the catalyst to book profits during or right after second-quarter earnings season.

Monetary policy will always be the great arbiter for the stock market. It is the most powerful catalyst for price changes. But after the Federal Reserve’s actions come earnings, and companies do have to perform in this area.

I continue to view the equity market as being very high-risk for new positions, recognizing that there are very few other asset classes for long-term investors to consider.

In each of the last three years, the stock market has taken a meaningful break over the summer months. It feels stretched and a repeat of previous summer performances is definitely in the cards.

I think the investment community itself is very surprised by the strength and fervor that institutional investors have bought this market. The earnings picture doesn’t particularly support a rising stock market. While it is true that valuations remain historically reasonable and corporations have done a good job improving their balance sheets, the lack of momentum in earnings growth and revenues over the last number of quarters is at odds with historical sentiment.

The stock market is due for everything—a down quarter, a major two- or three-day crash, and a massive correction. The system has earned it.

With big traders speculating on global monetary stimulus, fund managers are paid to play and are still nibbling.

But there definitely is pronounced fatigue apparent in the equity market now. As well, second-quarter earnings expectations are looking tired.

Capital markets are now searching for the equity correction. All that’s required is enough of a push and the sell button will be switched to “on.”

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