Dark Clouds Gathering The Financial Markets

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dark clouds financial markets

We have been on alert for the last few weeks as the financial markets are faltering. Not necessarily on the surface, as new all-time highs were put on the board in the past few weeks, but the wood is starting to show through the paint. Underneath the surface, there are a few things that do not make us feel very comfortable. It is not a feeling we are used to, as we have been positive on stocks in general since late 2010 due to the monetary inflation. Three years later, however, there are a few factors that have caused some raised eyebrows, including ours.

In the first place, volume is visibly dropping and the rally is losing momentum. In other words: the pool of (new) buyers is drying up and when a market hits its head on the ceiling a few times, it will come down; sometimes hard and fast! Another point we see, is that sector rotation is dominating the market. While 2013 was a year of spectacular profits for technology and other cyclical sectors, we are noticing that the strongholds of the market today are sectors like energy, utilities, telecom… boring traditional market segments, if you will, but also sectors investors reach for in times of uncertainty. The below chart from StockCharts.com clearly shows that these sectors were leading the market last month, while technology and other cyclical sectors could not hold on to their returns.

stocks sector rotation 2014

(Source: StockCharts)

With the second quarter of 2014 now well on its way, it is obvious that the markets have not really pushed onward this year, in stark contrast to the years before. We have not forgotten about the bad month of January, of course, and the tough first couple of days of the year for the stock market, as history indicates that a difficult start often weighs down the performance of the market for the rest of the year. Although we are only one quarter and a few days in, that is exactly what is happening however, and we fear that the coming months will not be a walk in the park as well. April is usually a great month for the stock market, but afterwards everything generally goes downhill quite quickly in May, June, and the summer months.

The question that we are most concerned with is the following: are we about to experience another mild correction, or is this the year when the market gets the wind knocked out of it? Considering the fact that we have been on the rise for a few years now, without any kind of correction that is worthy of mention, the latter option might be closer to the truth. Let it be clear that we would welcome a correction with open arms, as markets never rise in a straight line. Today, a lot of stocks also have a lot of expectations priced in them already, while the economy is not visibly picking up steam at the same time. The stock market is getting ahead of the facts and reality, which is never a great starting point for an investor.

As the profits of publicly listed companies – the driving force behind the stock market – are not showing a lot of promise, valuations are creeping up fast as well. If we do not see any positive developments in the coming months in that regard, it will be time to hold on to our hats, and economic indicators are not really helping to lighten up the mood. Even more, they are ominous and hint at darker days. A great example is the recent free fall of the CESI, the Citigroup Economic Surprise Index.

CESI 2014

(Source: Thomson Reuters / Twitter @beursanalist)

The CESI tracks economic expectations in relation to actual market data, and the number of positive surprises have been replaced by spikes to the downside, while the global markets (MSCI World index) are not budging. Now, you could say that the CESI also took a dive in 2012 and 2013 while the stock market held its own. Although that is correct, we have to underline that the central banks, especially the Federal Reserve, were always ready to step in with monetary injections to prevent the worst from happening. Ben Bernanke started his career at the Fed with a crisis of epic proportions in 2008, after which he switched on the printing press to prevent the financial markets from collapsing.

Janet Yellen, however, is slowly turning that printing press off, which is something investors are not too happy about. The question whether the markets will correct this year or not, is answered consequently with the next question: will the Fed come to the rescue again when the walls come crashing down? At the moment, it is anybody’s guess as Janet Yellen has no track record with regards to these types of situations.

Even if Yellen stays the course of scaling back quantitative easing, however, we do not expect a repeat of the crash of 2008 as interest rates and the inflation rate are still low, and will most likely remain that way for the foreseeable future. A decent correction followed by a period of consolidation seems like a more realistic scenario for now. However, clouds are gathering over the stock market and we are keeping a close eye on the developments, as a move from any central government could push it one way or the other. Also, a jump in inflation could cause markets to tumble quickly. That is why we are advising our subscribers to strengthen their cash positions and hedge (short) against a potential stock market decline (to protect their sizable returns). And last, but not least, buy some gold and gold stocks.

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