This blog post originally appeared on RealMoney Silver on March 29 at 9:02 a.m. EDT.In his seminal book Margin of Safety, hedge fund manager Seth Klarman tells an old story about the market craze in sardine trading. One day, the sardines disappear from their traditional habitat off the Monterey, Calif., shores, the commodity traders bid the price of sardines up, and prices soar. Then, along comes a buyer who decides that he wants to treat himself to an expensive meal and actually opens up a can and starts eating. He immediately gets ill and tells the seller that the sardines were no good. The seller quickly responds, "You don't understand. These are not eating sardines; they are trading sardines!" Similar to Klarman's tale, today's market is a trading-sardine market, not an eating-sardine market. As previously noted, there appears to be no real trend nor is there likely to be one over the short term. Instead, a range-bound market confined between 1,250 and 1,350 on the S&P 500 seems to be a reasonable expectation. In all likelihood, we probably hit a low for the next few months at around 1,250 on the S&P on Japan's "Nuclear Wednesday" a few weeks ago. In that case, profit-taking was absorbed without a severe setback, a classical sign of a good bottom. But there are numerous fundamental and technical factors that support the notion that the upside might be limited, too. For now, buying the dips and selling the rips, which is good for opportunistic traders but bad for the buy-and-hold crowd, seems a reasonable tactical response to these conditions. The core challenge to the markets? Upside surprises, both profit and economic, have likely peaked, and downward revisions will probably occur with more frequency. There is more economic and profit ambiguity emerging, and the consensus profit forecasts for the S&P have become the best case and are no longer considered the likely case. The good thing is that bullishness has ebbed, and there is some fear. Animal spirits have subsided, and valuations are not unreasonable. I continue to believe that comparisons to the market correction in November 2010, which morphed into another bull-market leg, are not yet in place. What would make me more positive technically would be a shift out of the defensive area (a deterioration in consumer staples) and/or a breadth thrust accompanied by a 90% up day. These are the conditions that reversed the November 2010 correction.
For now, neither development seems to be forthcoming. Consumer nondurable shares, including Colgate-Palmolive ( CL), Clorox ( CLX), Kellogg ( K) et al., remain strong. And I don't see a 90% up day around the corner. Fundamentally, as I have written extensively, risks appear elevated (and could be rising), likely capping possible stock gains over the near term:
- Higher energy and other input prices. Higher energy costs remain the biggest risk to profit and economic growth. Japan's nuclear crisis has likely further increased our dependency on fossil fuels. U.S. policy is on a slippery slope on which oil might be increasingly impacted by the outside influences of Mother Nature and political developments -- all beyond our control. Besides energy prices, a broadening increase in input prices also threatens corporate profit margins. Meanwhile, these factors are pressuring the consumer, as gains in real incomes, adjusted for several extraordinary factors, remain relatively weak. And, as The Wall Street Journal duly noted, screwflation of the middle class remains a further challenge to forward personal consumption expenditures and to aggregate economic growth. Already, the consumer is dipping back into savings, a worrisome sign.
- Confidence. Consumer confidence is dropping, reflecting current events and continued screwflation of the middle class. The Gallup confidence and the University of Michigan sentiment surveys have been disappointing, and, as I mentioned last month, investors should watch the HOLDRS-Retail (RTH) closely for clues of future spending growth. (It looks like a broken chart.)
- Middle East/North Africa. Geopolitical risks abound (and will likely linger) in the Middle East, despite the recent unified efforts to upend the regime in Libya.
- Housing. The residential real estate market remains moribund; any further weakness in home prices will serve as a drag and will jeopardize confidence, consumer balance sheets and economic growth.
- Monetary policy. Exiting QE2 will have an uncertain impact, so will recent monetary tightening in India and China.
- Tech questions. We have renewed tech inventory and demand concerns in the defense (e.g., Sanmina-SCI (SANM)), optical (e.g., Finisar (FNSR)) and tablet spaces.
- Supply disruptions. In our increasingly interconnected world, the Japanese nuclear crisis has caused numerous supply disruptions in tech, autos and other industries.
- Slowing business momentum. Given the confluence of events, first-quarter 2011 business activity likely ended weaker than expected. If businesses begin to treat the geopolitical and elevated oil prices as a more permanent condition, order cancellations and corporate-spending deferrals loom in the months ahead.