Catalysts for a Correction


Well my birthday week was good for the domestic markets as most ended up about 3% bringing us back to near the even line for the year. So far in 2015, we have had the type of volatility that I foreshadowed back in my October and January letters to clients of my firm and my opening letter on MarketWatch this year. In those articles I went over investments to avoid and asset allocation thoughts. 

The Big Picture

What we know about the U.S. stock markets and many others are that we are somewhere in the process of putting in intermediate term tops. This sort of process usually takes two or three years to finish. Interestingly, a topping pattern doesn’t always lead to a crash right away. It will always include some corrections however. Our first mini-correction was this past October where we did see a fall in markets exceeding 5% and almost 10% intraday.

I first noticed the topping of the markets begin in late 2013 when small investors started to crowd into equity markets again after sitting out for several years. In response to my observation, I wrote an article in MarketWatch titled “How Bad Will New Investors Get Hit.” 

I had previously reminded people not to get “I’m-missing-it-itis” which is a disease that particularly afflicts investors. I issued that warning very early, hoping that it would serve as an innoculation. I will say, it might have helped a bit as I am have been getting a lot of calls since October when I put out the first volatilty warning.

Today, there is a lot of complacency in the markets. Small investors continue to put money into the markets via their 401(k) and other retirement plans. What I have been able to identify by watching various money flows is that many big investors are selling into the stock market’s recent strength. With the end of contribution season in retirement plans nearly here, I am becoming very suspicious we are closing in our first 10% correction since 2011. I strongly suspect we see it in the second quarter.

I am not sure we get a full blown bear market however, which would require a 20% drop in markets. There is still a lot of loose central bank printed money out there that might come in and “bargain hunt” if prices fell across the board. There are about three dozen companies I’d be interested in, but not many more than that as earnings are clearly topping off. Remember this thought above all else if we get a correction or crash: buy quality when prices drop across the board. It does not pay to shop for speculative investments when we can get great companies on a rare cheap opportunity. 

Topping earnings are of course the harbinger of a bear market. Already companies and analysts have been brining down expectations. Much of that is to lower the bar for them to get over in coming quarters. Don’t fall for that trick. It is no reason to bless companies with higher multiples.

We can see from low productivity numbers the past couple years, a stronger dollar and now slightly rising labor costs that earnings, especially at the large multi-nationals, will be hard to improve any longer. With those large companies seeing flattening earnings, it won’t be unusual to see investors panic.

That is not the whole picture though. Multi-nationals only support about 15% of the economy. The rest of the economy benefits from the things that challenge multi-nationals. Small domestically focused companies should do very well with lower energy costs and a stronger dollar. The same can be said for about 98% of Americans. Mid-size companies will be split as some are going to feel the same pressures as the multi-nationals, while others benefit – we will have to be very selective there.

One of the places we will continue to find opportunity is in the natural gas space. With Cheniere’s Sabine Pass coming online in Q4 we will see the beginning of a boom in natural gas stocks. I have highlighted several opportunities already in our young existence with this service.

Catalysts to a Correction

There is no shortage of headlines to worry about that might tip us into the correction I am seeing coming, my quant guy extraordiniare Rick agrees with the correction sentiment by the way, more on that below. 

First among worries should be that global growth is simply bad right now. Japan is in recession, Europe is teetering and China is slowing down dramatically as they try to clean up everything from graft to overbuilt ghost cities.

I worry about Asia in the short run. The transition there amoung the major economies is not a smooth. South Korea joins other major economies as not doing so well. I am very concerned for the first time about China’s growth numbers – I don’t invest there because I don’t trust their markets, legal system or corporations – and the impact that could have. I think Jim Chanos is very close to getting his billion dollar payoff there. 

I have mentioned before that I think Japan is doomed to a Greece-like fate, although, I think that will be years from now. 

Greece’s fight with Germany is coming to a head and while I hate to agree with Alan Greenspan, as I think his public pronouncments have been horrible for a long time, there is a good chance that we do see the Grexit. Short run that would be traumatic to markets. Longer-term it is hard to say the effect.

I also am concerned about Russia. This might be the most dangerous problem in the world. I agree with Jeff Gundlach that we are on the brink of some very bad things if there are no resolutions with oil prices. As I have explained before, oil prices are directly tied to foriegn policy goals with Russia. Anybody who doubts that at this point just isn’t reading. 

If there is no resolution with Russia over Eastern Europe – I am submitting an opinion piece to the New York Times soon – and pressure on Iran for a nuclear deal from Russia soon, we truly could see what Gundlach called “terrifying.”

In addition, the world is still in a type of central bank instigated and mitigated depression. I am not certain why people do not realize that growth is demographics dependent at its base level. All of the monetary fixes in the world can not increase aggregate demand without actual production increases. Production increases at this point can only come from attending to the trillions of dollars worth of deferred maintenance on infrastructure that irresponsible governments have skipped for years in order to create transfer payments intended to buy themselves favor and votes (in those nations that vote). That is why eventually, I will be very high on companies that can take part in that rebuild of the world. It is coming, it’s just a matter of do we have to hit rock bottom first. 

Correction or Crash

I am in the camp that we see two or three 10% to 20% corrections in the next year or two. Rick believes we are closer to a crash. Rick might be right as the analytical charting math seems to support him.

Here’s my belief. I think we are much more in danger in a few years of a collapse. I think this because the central banks are still printing, see the ECB, Japan and China, and politicians are still applying band-aids. Eventually the printing has adverse effects and band-aids don’t hold.

For the time being, I’ll stick by my analysis that 2015 will be a lot like 2011. There will be opportunities to pick up great companies. There will also be more opportunities than I like to trade. As subscribers see, we do have a couple positions now that can benefit from corrections not only in equities, but also currencies. 

Kirk Spano

 

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