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Why US Stocks May Be Poised For Declines

By Michael Arold

I believe the month of May gave us a good example of how unstable markets can be, even if they are in trending mode. Examples include REITs, Japanese, and Turkish stocks. As of May 31st the Nikkei 225 Index fell over 16 percent in eight days after rallying almost 50 percent in 2013.

Utilities (XLU) declined 10 percent after a 17 percent gain in 2013. The Turkish stock market declined 10 percent after gaining 15 percent this year. These sell-offs occurred within the last two weeks of May.

One could not "prepare" for them using traditional technical analysis methods: no "head and shoulders top" or "momentum divergence." Maybe the declines turned out so strong because of the surprise factor.

The sell-offs also show that market character has changed: almost every global equity market rose during the first half of 2013, but stocks are not moving in lockstep anymore. The declines beg the question who is next.

In all cases it was sentiment, not the fundamentals, that suddenly shifted. I believe we have to recognize that a similar emotional change could (I did not say "will") happen to US stocks anytime. Should it occur, I believe one will have to move fast to protect this year's gains. That's why I'm monitoring the markets closely every day.

A potential catalyst for a major sell-off in US equities could be the notion that the Fed’s easy money policy may not be an effective instrument to improve economic conditions in America. The latest PMI index reading on June 3 showed that US manufacturing has been losing steam.

In the past, similar bad news had been good news for stocks because it kept Fed hawks in check. The market could become interesting if bad news suddenly gets recognized as what it is: bad news.

I believe enough potential energy has accumulated to fuel a major decline: NYSE margin debt records at all-time high, so investors are heavily leveraged.

Not everything is bad, in my opinion, though - small caps have been holding up well and the Russell 2000 has been outperforming the more conservative S&P 500 Index in the last weeks, a bullish sign.

Technology and financials are two sectors I like and, in my opinion, could provide leadership for the next leg up. Still, continued QE3 support and lack of investment alternatives offers a tail wind to the markets. Technically, US indices are still in an uptrend and the market remains “innocent until proven guilty.”

However, in order to accommodate for the latest period of increased uncertainty, I raised cash levels and try to be more selective with my positions. The goal is to not get “chopped into pieces” after a strong May, where the Covestor Technical Swing Portfolio gained 6.9% (net of fees) while the S&P 500 rose 3%.

* * *

Get to know Michael:

The investments discussed are held in client accounts as of May 31, 2013. These investments may or may not be currently held in client accounts. The reader should not assume that any investments identified were or will be profitable or that any investment recommendations or investment decisions we make in the future will be profitable.
Michael Arold

Michael Arold

I am a technical trader and an aerospace engineer with more than 15 years of investing and trading experience. My

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