Market Conditions Too Good To Be True? My Plan For 2014

Coincident indicators were generally positive, but less strongly so. Steel production is positive albeit more muted. Bank lending rates remain at or near record lows. House prices remain strongly positive. Tax withholding retreated after an excellent November. Gallup consumer spending remained quite positive, despite challenging YoY comparisons, Johnson Redbook was moderately positive, but the ICSC index less so.

My mantra remains the same. The economy has bounced back in the second half of this year, and all looks well for the next 3 to 6 months. Housing and especially interest rates must be watched carefully, however, as to the end of 2014 and 2015.

In particular, the bond market's reaction to the inevitable Fed tapering, whenever that occurs, has to be watched very carefully. Will long rates start to back up and push up mortgage rates and dampen growth in the cyclically sensitive housing sector?

Meanwhile, European leading indicators are still pointing up, though coincidental indicators still look punk. The ECB has made it clear that it is prepared to give the market a Draghi Put, which is supportive of growth. China is growing, albeit in an unbalanced fashion.

Simply put, global growth is continuing and there is little or no tail risk in the immediate future. It's time to get long equities. What could possibly go wrong?

Too good to be true?
Maybe it's because I apprenticed under people who lived through the terrible bear market of 1974-75 that I worry so much, but I have this nagging feeling that these market conditions are too good to be true.

If you look, there are a number of technical and fundamental clouds on the horizon. John Murphy (subscription required) pointed out that 2014 is the second year of the Presidential Cycle, which is usually not equity friendly [emphasis added]:

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According to the Stock Traders Almanac, the two first years of the four-year cycle are usually the worst with the last two usually the best. Bear markets usually occur during the first two years. Since 2013 (the first year of this term) was so strong, historical odds for 2014 (the second year) to suffer a downside correction are pretty high.

Chart 1 overlays four-year cycle lows on the SP 500 going back to 1990. The vertical bars show the last six bottoms occurring in 1990, 1994, 1998, 2002, 2006, and 2010. Earlier four-year patterns (not shown here) occurred in 1970, 1974, 1982, and 1987 (the cycle skipped 1978 while 1987 was a year late). Most of those bottoms took place during the second half of those years (mainly around October), and have coincided with midterm congressional elections. Assuming the four-year pattern repeats, the next bottom is due in 2014 and most likely during the fourth quarter. That carries both good and bad news. While the second year of a presidential term (like 2014) is usually the weakest, the third year (2015) is usually the strongest. The bad news is that 2014 is likely to experience a major stock correction. The good news is that correction should lead to a major buying buying opportunity later in the year.

Growth and Value bears come out of the closet
Besides the technical headwinds posed by the Presidential Cycle, a couple of well-respect growth and value oriented investors are turning bearish. Mark Hulbert pointed out last week that the Value Line Median Appreciation Potential, which has a growth tilt, hasn't been this bearish since 1969:

To be sure, the market may resolve its current critical juncture by headed higher rather than turning down. Yet Aronson notes that other indicators are also flashing caution.

One to which he draws special attention is known as the Value Line Median Appreciation Potential, or VLMAP, for short. This represents the median of the projections made by Value Line’s analysts of where the 1,700 widely followed stocks they closely monitor will be trading in three to five years’ time. But for brief exceptions, the VLMAP currently is lower than it’s been in many decades.

For example, the VLMAP today stands at 30%, where it’s been for seven straight weeks. Prior to the October 2007 peak, it got this low for just one week. And it never got this low in the months leading up to the 2000 market top.( Read a column I devoted earlier this year to the VLMAP . )

In fact, you have to go all the way back to early 1969 to find another time in which the VLMAP spent as long a period at 30% or below. From then until the market’s December 1974 low, of course, the Dow fell more than 40%.  

As well, legendary value investor Warren Buffett has stated while equities look fairly valued, he can't find anything to buy, though he did allow that:

[Buffett] noted that the equity market was fairly valued and stocks were not overvalued. Specifically, Buffett said “They were very cheap five years ago, ridiculously cheap,” and “That’s been corrected.” He also noted, “We’re having a hard time finding things to buy.” One has to take note when the world’s most high profile investor (a long investor), cannot find stocks to buy although he reports his business is improving.

This is a case of watching what Buffett does, not just what he says. When he says that he can't find anything to buy, you have to start getting cautious. When both Growth (VLMAP) and Value (Buffett) are cautious, then investors have to get especially wary.

Positive momentum, long term caution
The combination of positive short-term indicators and analysis from Value Line, Buffett et al point to the same thing. Short term momentum remains positive and stocks remain in a multi-year uptrend...