Sifting Through the Correction Noise

Last week was a bad week for stock markets... not just here, but globally. Many of the bears have come out of hibernation and called for the start of THE correction. I'm well-read on each and every bit of information they throw out to support their case, because I agree with (pretty much) all of itl the global economy is not growing, monetary policy isn't working, etc. I am in their camp when it come to being "bearish" on the economy...

Where I differ with them is their opinions on stock markets. Yes, I believe stocks are significantly overvalued. Yes, I believe that QE and ZIRP have caused massive miss allocation of resources in the economy. But do I believe that this is the tipping point? The start of a correction? Maybe. A reversal in trend, and potentially a bear market? Absolutely not!!

If you have been short the market at any point since 2009, you have lost money. Even looking at this year you have lost money, even as the Fed has been tapering off QE and discussing rate hikes. In late January and into early February, stocks had a nasty sell off due to the Ukraine crisis. What happened after? Stocks went higher. In April, stocks sold off because technology stocks were thrown out of favor by investors, mostly the nose-bleed value ones that generate no profit. Stocks went higher after. In early August, stocks sold off on the back of more negative news. Stocks went higher after.

The bears claim that this time is different. They have been saying this for years. It is NOT different! They claim that stock markets declining past their 200 day moving averages means more turmoil is ahead. While no one can be sure if this is going to be a full on correction, I highly doubt that this is the start of a reversal. And I've been calling for "this correction" since the beginning of the Summer. 

First of all, ZIRP isn't going anywhere! Nobody in the US economy can afford higher interest rates, not even the government! All this talk of rate hikes is meant to spook investors and let a little air out of the bubble. The Fed may follow through with "ceremonial" rate hikes - 50 or 75bps - as to look like they've kept their word.

Some excuses they may use for not raising them further may include:

1. "Inflation is not running at our long term objective of 2%"
2. "The labor market still shows slack"
3. "Higher inflation can be tolerated after years of low inflation"
4. "We don't want to cut off the recovery as soon as it finds its footing"
5. "Recent trends in the currency market have allowed the committee to be less constrained in their timing of further rate hikes"

The FOMC has been extremely selective in their choice of words recently. They have been whispering things like, "The market's idea of the timing of rate hikes are not in line with the committee's," or, "Investors are not perceiving the risk of losses as real." They're trying to let the air out! They know god damn well that a real rate hike is pretty much impossible.

One way to tell this is that the bond market is totally calling the Fed's bluff. Look at 10 year treasury yields YTD for 2014:

Yields have done nothing but decline even though inflationary pressures have continued to rise and the Fed has been tapering QE and discussing rate hikes.  In fact, they are at their lowest level since the taper tantrum in May of 2013! 

#5 in the aforementioned list refers to currency market trends. Since investors on the whole believe that a rate hike is coming, and the ECB is planning to unleash a QE program and Japan prints indefinitely, the Dollar will appreciate in relation. The markets have already priced in a potential rate hike. What happens when that silly notion dissolves? Let's look to the past:

In 2010 the Dollar had a massive rally on the backs of the European debt crisis and the belief that the Eurozone may break up. That didn't happen, the crisis was largely contained, and the fall in the Dollar was just as precipitous as the rise! You mean to tell me that slowing growth in Europe and an obvious balderdash of a rate hike justify a rally in the Dollar like the Euro crisis did?! No, and it will soon decline as that realization sinks in.

In conclusion, while a correction is long overdue and may occur in the following weeks, it is very likely not the start of a reversal.