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February 25, 2014

Chart of The Day: S&P New HIghs.... Now What?

By Lance Roberts at Street Talk Live

Chart comparisons predicting the next major market crash have abounded as of late.  Is this a repeat of 1929, 1974 or 1994?  The truth is that we are all guessing at what will happen next in the markets as no one really knows what will happen tomorrow much less six months from now.  I say that to qualify today's chart because the market is behaving very similarly to what we witnessed beginning in late 2010.

What is interesting about the chart above is that in late 2010 the markets were rising strongly as the Fed's second quantitative easing program was fully engaged.  Complacency among investors was high as the economy plugged along.  Much the same as we are witnessing currently.  Then, in March of 2011, the Japanese trifecta of economic disaster struck as an earthquake caused a tsunami which led to a nuclear plant chain reaction.  The only thing missing was a 90 foot tall lizard sending citizens fleeing from the city.

The domestic economy was quickly impacted by the shutdown of Japanese manufacturing.  Economic data began to wane at the same time as the Fed's liquidity program approached its early summer expiration.  As the market anticipated the reduction in liquidity flows from the Federal Reserve, stock prices began to struggle. However, for a while they managed to hold above important support.  Then, in the middle of summer, President Obama squared off with Congress over a heated debt-ceiling debate.  Threats of a government default filled media headlines while market participants watched helplessly from the sidelines.  While there was never any real threat of a default, as witnessed by the plunge in U.S. interest rates to record lows at the time, the markets plunged sharply over just a few short weeks causing investors to flee for safety.

That was then.  Interestingly, we are currently witnessing similar events. 

The Fed is once again tapering their current liquidity program.  The most recent commentary from the Federal Reserve suggests that the current path of reduction in bond purchases will continue which suggests the program will end by October, 2014.

While the U.S. has not yet witnessed an "abominable snowman" threatening Manhatten, the series of "polar vortexes" are exacerbating already weaker trending economic data.  As I discussed previously, the pop in economic data in Q3 of 2013 was an inventory restocking cycle. 
"It has been a 'Summer of Recovery' for the U.S. economy with GDP growth rising from 1.1% in the first quarter to 2.5% in the second and manufacturing surveys showed sharp jumps in new orders and outlooks.  The same occurred in the Eurozone with Markit's PMI reports showing sharp bounces higher and hopes that the recession that has plagued the region was finally coming to an end.  The question of sustainability remains.
I have noted several times as of late that the recent bumps in economic activity, particularly in the survey and sentiment data, is most likely due to short term restocking activity rather than actual economic improvement."
That point was reaffirmed by the NFIB's Chief Economist, Bill Dunkleberg, just recently:
 "Last year finished with a fair uptick in economic activity, but probably not as strong as the 'headline' GDP numbers made it look. Overall, GDP was up only 1.9 percent in 2013, down from 2.8 percent in 2012. But the second half of the year posted above trend growth numbers, a rare showing in our 5 year recovery. Exports were strong, that’s good for manufacturing output, but less so for jobs – productivity looking good. A huge share of the growth was in inventory building, nice while it is happening, but usually followed by sub-normal production later as excess stocks are worked off. That will depress activity in the first half of 2014 and keep some prices down."
With that restocking cycle now complete, the economic data was already showing signs of weakness.  However, the exogenous shock of the extraordinarily cold winter has sent utility costs surging, slowed production and reduced incomes.  While not as economically damaging as the "Japan shutdown," when the effect of the winter impact is combined with the rising costs, taxes and uncertainty created by the Affordable Care Act, the economic drag will likely be exacerbated.

Lastly, we are in a mid-term election year which typically does not bode well for markets just prior to the November election.  This is an issue I discussed previously stating:
"Midterm election years are also notoriously weaker when Democrats are in control, but in the last 13 quadrennial cycles since 1961, 9 of the 16 bear markets bottomed in the midterm year.
As stated, on average all midterm years have returned 4.16%. However, when the midterm year followed a strongly positive post-election year, as in 2013, that return fell to just 2.4% on average.  The chart below, from Stock Trader's Almanac, shows the mid-year correction that generally accompanies a mid-term election year."
DJIA-Midterm-Election Years
While mid-term election years have typically finished on a positive note, it is important to note the corrections that tend to occur prior to the election in the chart above. 

So, while there have been plenty of charts comparing this year to that, the current combination of both the technical setup and economic backdrop should raise a cautious view.  Since no two periods are ever alike, it leaves us guessing at the future when making investment decisions.  Unfortunately, while psychics and fortune tellers have the "crystal ball" market cornered, the rest of us are forced to take our ques from what has happened in the past.

Courtesy Lance Roberts at StreetTalkLive.com (EconMatters author archive here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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