The Equity Market's Slow Burn and Mounting Risk Dislocation...

ARMS & THE COVENANT

 

In 1940, then Harvard undergraduate, John F. Kennedy penned his college thesis on the cause and affect of England's torpor in the face of mounting fascist aggression just beyond its own shores in the 1930s.  The thesis was a reconnoiter of Churchill's While England Slept, which was originally published under the title, Arms & the Covenant.  In his subsequent examination, Why England Slept, the young aristocrat was careful not to lay blame at the feet of those who have come to be associated - justly or otherwise - with history's cursory allocation of abetment.  Perhaps the conspicuous omission was prelude to a fateful temperament that would save humanity or perhaps it was because one of the damned was his omnipresent benefactor and father, Joseph P. Kennedy.

Today, domestic equity indices are staring down increasingly ominous signs that threaten their 7-year bull market with reminiscent apathy.

Obviously, the modern threat of a needed correction to a bloated equity market is in no way comparable to global threats fascism presented to the world in the 30s and 40's... but World War II is one of my favorite subjects so I'm sticking with the parallel.  

Let's begin by taking a glance at the behavior of the S&P in recent weeks as seen in the chart below...

For the past 5+ weeks, the benchmark index has been forming a bearish technical pattern and is now trading below its three primary moving averages.  Furthermore, the gap between the 20-day and 50-day averages is negative and expanding to the downside.  If the current slow-burn trend continues, the 50-day will soon cross below the 100-day moving average in what is known as a 'death cross' to traders.  These are all classic indicators of an increasing probability of a market correction.


THE TEFLON BULL - NOTHING STICKS

But what makes this blip different from so many of the other false bottoms the market has stared down in the past 7 years?  After all, this bull market has seemingly been woven from teflon cloth and hermetically sealed in kevlar casing... nothing sticks, nothing dents it... this bull market is, for all intents and purposes, invincible.

I know this all too well as I have sounded the alarm on pending doom before only to see the storm clouds pass with little more than a couple of harmless claps of thunder.  At the risk of being labeled a Chicken Little, however, I'll take another shot.

Over the past 7 years, this bull market has feasted on unprecedented amounts of stimulus; first in the form of main-line adrenaline from federal bailouts to continuing subsidies from quantitative easing to record levels of dovish monetary policy in both orders of magnitude and duration.  As I've stated in the past, any hint of positive economic news has given this market pause while it has seemingly rejoiced at indicators that might serve to prolong its nursing from policy makers.

http://tancockstradingblog.blogspot.com/2015/10/through-looking-glass.html

However, after nearly 8 years of a progressive administration - and with at least 4 more seemingly on the horizon - the market may now be pricing in its new reality.  This new reality is one of government regulation, higher taxes and higher costs of doing business.  This new reality has shown recent signs of taking hold as, for the first time in years, median incomes are rising and the labor participation rate finally begins to show signs of life.

These signs are important to the market for one key reason... they are forward indicators of inflation.  Inflation, or lack thereof, has been the thing that all the monetary stimulus in the world could not move over this market cycle.  The United States was in jeopardy of falling into a pricing slump reminiscent of Japan's lost generation in the absence of fiscal stimulus.


IT'S THE ECONOMY, STUPID

If elected, Hillary Clinton has promised to make economic expansion the primary focus of her presidency.  While it's naive to think that she can reproduce an economic engine similar to the one that defined her husband's administration, her pledges of increased infrastructure spending and higher federally mandated minimum wages are expected to promote further inflationary expansion.

It is this inflationary expansion that I believe the market is currently pricing in as it would give the Fed the needed impetus to unwind its long-held easy monetary policy in earnest


WHY VOLATILITY SLEPT

In spite of the warning signs of increasing threats to the equity markets and a renewed dollar rally, the price of risk remains relatively low as the VIX closed Friday trading at only 13.34.  It is worth noting, however, that last Friday was an options expiration day at which point the underlying futures contracts rolled over on a normal curve in what is known as contango.

Regardless of semantics, the collection of market indicators in combination with a lax reaction in perceived risk tells me that markets are most likely viewing the changing political landscape as a point of inflection in market forces and not a parabolic shift in macroeconomic policy.

Only time will tell if this market is properly priced or if it's the economic equivalent of Neville Chamberlain.