Four Reasons To Respect The Bearish Case

The Glass Half Empty Quad:

1. The Fed will phase out QE
2. Waning bullish conviction
3. Deflationary forces
4. Tepid global growth

Bullish Case Has Been Covered

Regular readers know we have backed up the longer-term bullish case with evidence from defensive consumer staples, the VIX Fear Index, and ETF leadership. Financial markets have almost an infinite number of moving parts. Consequently, understanding bullish and bearish arguments allows for a more balanced view of investment risks. Today, we examine the investment landscape from a glass half empty perspective.

The Fed Will Phase Out QE

If you follow the financial markets closely, and more importantly understand the mechanics of the Fed’s quantitative easing (QE) programs, you cannot overstate QE’s impact on the stock market. QE matters and a market without a QE tailwind may struggle unless the global economy can grab the baton from the Fed. In his latest investment outlook, Bill Gross, the manager of the world’s largest bond fund, wrote:

“The Fed will have to taper, cease and then desist someday. They can’t just keep adding one trillion dollars to their balance sheet every year without something negative happening – either accelerating inflation, a tanking dollar or a continued unwillingness on the part of corporations to invest because of the resultant low and unacceptable returns on investment. QE has to die sometime.”

Waning Bullish Conviction

In this week’s video, we referenced slowing bullish momentum as an increasing concern. What exactly does that mean from an economic and technical perspective? The technicals allow us to monitor the never-ending battle between bullish economic conviction and bearish economic conviction. When bullish economic conviction is much greater than bearish conviction, the markets have positive momentum, which can be seen via the steep slope of the Dow’s 50-day moving average below (labeled A). When the battle between bullish and bearish conviction is relatively even, the result is a slope like what we have now (see B). Slowing momentum has been helped by the fear of how markets will react to tapering by the Fed.

Deflationary Forces

Credit bubbles fuel overconsumption. During the bubble years, consumers borrowed money and loaded up on everything from HDTVs to vacation homes. During periods of overconsumption demand tends to get pulled forward, which creates buying power gaps in future years. Econ 101 tells us air pockets in demand can create lower prices. If you want to learn about the negative effects of a deflationary spiral, Google “Deflation in Japan”. The Fed is concerned about falling prices, and thus could delay the tapering of their bond buying program.

Tepid Global Growth

Are the deflationary forces in the global economy real or imagined? The Fed has been pumping unprecedented amounts of freshly printed money into the global financial system via QE. Despite extremely loose conditions on the monetary front, the global economy remains tepid. From CNN:

Business at FedEx remains solid and investors are pleased, but the shipping giant isn’t very optimistic about the global economy. Though the company reported better-than-expected fiscal first-quarter earnings, FedEx CEO Fred Smith says the company continues to face “challenging global economic conditions.”

Investment Implications

The concerns outlined above should be respected, but harder evidence of a bearish turn is needed to change to a glass half empty allocation. Bearish confirmation can come from a variety of sources, including a shift toward defensive ETF leadership, a spike in the VIX Fear Index, or a negative turn in economic trends.

Our market model allows us to monitor the aforementioned battle between bullish economic conviction and bearish economic conviction. The bulls still hold a slight but discernible advantage over the bears. However, the bulls’ grip is not nearly as tight as it was earlier this year. The current climate allows us to continue to hold diversified ETFs with exposure to U.S. stocks (VTI), developed markets (EFA), and emerging markets (EEM). Our holdings in small caps (IWM) and technology (QQQ) continue to outperform the S&P 500 Index.

This entry was posted on Wednesday, October 2nd, 2013 at 2:58 pm and is filed under Stocks - U.S.. You can follow any responses to this entry through the RSS 2.0 feed. Both comments and pings are currently closed.