Pointing to a Pullback
Furthermore, investor sentiment has reached euphoric levels, the market is overbought and the VIX recently hit its lowest levels since 2007. Capitulation is everywhere and the bears are running for cover. Acorrection is overdue and the cycles we monitor warn of a soft patch ahead. According to our friends atHussman Funds, present market conditions are not exactly welcoming and now match only six otherinstances in history: August 1929 (followed by the 85% market decline of the Great Depression),November 1972 (followed by a market plunge in excess of 50%), August 1987 (followed by a marketcrash in excess of 30%), March 2000 (followed by a market plunge in excess of 50%), May 2007(followed by a market plunge in excess of 50%), and January 2011 (followed by a market decline limitedto just under 20% as a result of central bank intervention). “These conditions represent a syndrome of overvalued, overbought, overbullish, rising yield conditions that has emerged near the most significantmarket peaks – and preceded the most severe market declines – in history." We are not ringing the '87 alarm just yet, but we do believe that a run-of-the-mill 10% correction instocks should not come as a surprise here, particularly considering that the first quarter of thePresidential Cycle has historically been the weakest, January’s performance notwithstanding. A pullback of this magnitude would be just enough to relieve overbought conditions and excess optimism and givethe SPY's one last run toward all-time highs before facing the long term realities of record high profitmargins and uncomfortably high valuations.
Looking for a Catalyst
Last week, markets reacted swiftly to the Federal Reserve’s growing discomfort with easy-money policiesas some suggested the Fed might tighten policy sooner than expected. While we believe the chances of anearly-end to QE are somewhere between slim and none, what we believe isn't worth a whole lot. Rather,the market will be driven by consensus expectations, and given the likelihood of rising inflation pressuresover the next couple quarters, those expectations will begin to shift their focus toward policy tightening,creating a large headwind for the market in the second half of the year. Granted, this headwind may arrive sooner than expected given the relentless spike in gasoline prices, as shown in the chart below.