Significant bearish catalysts at hand; harvest profits and increase downside protection.


UPDATE: April 10, 2013 (Technicals reject proposition) ——— 

On July 31, I posted an article expressing my continued cautiousness on the ambiguous macro outlook due uncertainty stemming from the upcoming September 12 German Constitutional Court’s decision (which ended up being Euro-friendly); nevertheless, I acknowledged that price action on the S&P 500 likely called for further appreciation and that small bets to the upside could be taken.  Since then the S&P 500 has advanced roughly 9%, on the back of Mario Draghi’s promise to do “whatever it takes” to save the euro, which marked a seismic shift in investor sentiment.  The “Draghi Put” was born.

Having said that, events this past week have made me increasingly bearish towards short-term performance (0-6 months) for risk markets. Investor sentiment surveys show a surprising complacency despite three major macro risks knocking on the door.

First: the outcome of the Italian elections, which resulted in the nation’s first ever hung parliament raises the specter of a political crisis. The result was actually rather unsurprising for me, since I had warned of such a scenario for years.  I admit that I was way too early on the call and experience has taught me that one can never underestimate the lengths to which euro area politicians will strong-arm each other to preserve the euro, despite clear signs that such a monetary union is destroying the social fabric of Europe. Nevertheless, clear political gridlock in the EMU’s third largest economy, which is tied to the world’s third largest debt market, greatly increases the risk of my feared political event upending the Eurozone monetary union. Conversely, perhaps European officials will engage in backdoor compromise and agree to some sort of solution, though I can’t see one happening anytime soon.

Second: while U.S. consumer spending reports in January and improving confidence reports in February showed a resilient US consumer, despite the expiration of the payroll-tax credit and higher gas prices, I believe that the effects of such a de facto tax hike will be reflected in consumer spending numbers in the months ahead as consumers adjust. A national savings rate of 2.4%, along with continued sluggishness in job creation, meager wage growth, and an increasingly cloudy global outlook is a precarious situation for bullish investors relying on improving consumption trends to carry the economy.  On the bright side, absent some geopolitical event in the Middle-East, gas prices should begin to come back down and provide some relief to the consumer. Furthermore, home prices are indeed supporting consumer psyche.

Third: along with the expiration of the payroll tax credit, we have the additional headwind of the sequestration; the $85 billion of mandatory across-the-board federal spending cuts spread out over the final 10 months of the year. While some analysts believe that the effects of the sequester will not significantly injure the ongoing recovery, when paired with the second risk above, economic growth is likely to underperform expectations, especially considering how bullish investors have become.

From a technical analysis standpoint, initial support of 1495 was broken earlier last week. This is cause for concern as the bulls were not able to hold that level and implies that the bears may be onto something with regards to the future outlook. Furthermore a series of lower highs, at least in the very short-term (Feb 19-28) are also worrying.  The bulls would need to break this developing trend and hold the 1495 level successfully to make me reconsider my bearishness. Important support levels, aside from 1495 are the 50-day moving average, currently at 1484 and major support at 1465.

After a healthy move higher in the S&P 500 since late July, a conflation of bearish macro headwinds has increased my cautiousness in regards to the immediate market outlook. I believe that profits should be harvested and downside protection should be increased given the powerful combination of renewed Eurozone concerns, the expiration of the payroll tax credit, and the ongoing sequestration. Sentiment surveys are pretty bullish and there is room for disappointment, particularly if the European situation is not resolved promptly.

UPDATE: April 10, 2013 (Technicals reject proposition) ——— 

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