Editor's Note: This article was originally published at 9:15 a.m. EDT on Real Money Pro on Sept. 25. Sign up for a free trial of Real Money.
The market is extended and the divergences I have focused on since early August are growing more conspicuous.
The weakness in the eurozone is beginning to affect European aggregate economic growth, and if this weakness accelerates, watch for systemic risks in the European banking system.
Maintain above-average cash reserves, be diversified across company and sector exposure, and avoid most overvalued social media stocks that have benefited from sponsorship by momentum-based investors.
I have learned that most strategists, money managers and letter writers welcome the safe haven of the crowd. As long as prices rise, they remain bullish. But those same groups will "turn" on the markets and become defensive if prices continue to drop, leaving retail investors in the lurch.
As well, examine the reward vs. risk in your individual stock holdings, and if the ratio is unattractive (or neutral), peel some off and take gains.
My most-preferred asset class remains closed-end municipal bond funds. I have numerous new investment ideas that have been the outgrowth of my research over the last few months, but I will only discuss them upon a broader retreat in the markets."
-- "Daily Diary," September 23, 2014
Futures have rebounded modestly from the last minute schmeissing on Tuesday (S&P 500 futures are +5 and Nasdaq futures have risen by 12 handles). As I mentioned earlier this week, a potential "dead-cat bounce" could occur in the mid- to late part of this week; however, it remains my view that we have seen "The Ali Blah Bah Top" (i.e., a top around the Alibaba (BABA) initial public offering) and, tactically, I plan to short that bounce.
According to Steve Starker and my good friends at BTIG, (consistent with my thoughts) an up day Wednesday may be followed by more weakness:
"During 2014, the longest consecutive losing streak for the SPX has been 3 days, with a solid gain on day 4 occurring each time.
However, following the day 4 bounce, the selling resumed shortly thereafter during 4 of the 5 instances, with a low being put in 3-5 days thereafter."
As previously noted, I am a (short) seller on any strength. As a measure of my conviction, in "Batten Down the Hatches," I reported that I even sold off a portion of some core investment holdings over the last two days, including Radian Group (RDN), Monitise (MONIF), Potash (POT) and Citigroup (C). (These stocks remain on my Best Ideas List, however, because of their intermediate-term reward vs. risk).
I was amused that several commentators in the business media this week couldn't find specific reasons for the recent market drops. By contrast, I see not only weighty technical divergences and narrowing breadth but also a host of fundamental concerns:
- Away from the U.S., economic activity is weakening. Italy, France, Spain, Russia and Japan are in recession. European real gross domestic product growth is perilously close to zero and a Japanese-style deflation is threatening the region. Based on recent data, the rate of growth in China's economy is decelerating. (I recently sold my iShares FTSE/Xinhua China 25 Index (FXI) long at around $42.50 for a near 25% gain over a three-month period.)
- The European Central Bank faces the challenge of structural issues. The ECB may be running out of gimmicks to spur growth in the quarters ahead. Moreover, the region's leveraged banking complex represents systemic economic risk for Europe and the world. Should the European Union fall back into recession, global economic activity will slow and will not only serve as a headwind to the U.S. and European profit growth, but it will also make it hard for peripheral EU countries to access capital markets and to finance deficits.
- Geopolitical pressures are rising outside of the U.S. and, unfortunately, there are plenty of reasons to believe that the world will be a powder keg for years. The Russian-Ukraine military confrontation is pressuring trade and economic growth -- that conflict, too, will likely be with us for some time.
- Housing activity continues to pause, and its foundation is fragile. Increased bank-capital requirements -- above those demanded under international banking regulations -- will further pressure the U.S. housing market and could tighten lending standards. (Mortgage purchase applications are down by 16% year to date)
- The automobile industry is exhibiting signs of peaking, and so are other durables, such as tractors and other heavy equipment, as posted in Caterpillar's (CAT) recent dealer statistics. Automobile inventory supplies are high and increasing, and aggressive incentives are being offered by car dealers and manufactures.
- A strengthening U.S. dollar is dulling our economy's prospects by hobbling U.S. export growth.
- Domestic growth remains sub-par and at "escape velocity," and sustainable growth still seems in question. With the 2014 results, the Federal Reserve itself has missed its U.S. economic growth forecasts for the fifth consecutive year.
- Inflation continues to run below the Fed's projections and, with the U.S. dollar strengthening and commodities collapsing in recent months, measured inflation is likely to continue lower.
- Personal consumption expenditures, in particular, look to be weakening. Payroll growth has fallen for the past three months, spending fell in July and August, and the screwflation of the middle class has persisted. The "exclusive prosperity" of trickle up economic policy since the Great Recession holds economic and social risks. None of these effects are likely to be value inflating for stocks.
As Jim "El Capitan" Cramer has noted, the market has become a "bearish playground." Err on the side of conservatism.