The S&P 500 fell almost 10% from its January 19th high to its February low. We wrote about the overbought market in our 2010 forecast and the likelihood of a 20% plus pullback sometime in 2010; the question is, has the expected decline already begun or is the market working off its overbought state by trading sideways for a few months (markets can correct in time instead of price, chopping sideways until earnings catch up with price). There is no question that the up trend from the March 2009 low is broken. Furthermore, with the 20-day moving average now below both the 50 and 100-day moving average, additional market weakness is a distinct possibility. Add in half a dozen distribution days (down days on heavy volume) since the January 19 high, and the case builds that the rally is on wobbly legs and will need to regain momentum in fairly short order if further profit taking is to be avoided (many institutional investors rely on charts to trigger buy and sell decisions, which is why charts are useful in the first place - circular reasoning I know, but very much a reality in the casino that passes for today's stock market). Further deterioration in the chart - in particular a breach of the recent 1042 low - will likely cause additional profit taking that could lead to our predicted 20%-30% 2010 decline.
As well, it is easy to build a fundamental case for further declines in the market. The S&P 500 is still about 20% over valued using $60 for earnings and 15x for a trailing multiple. (The S&P 500 has traded on average at 14 to 15x trailing reported earnings historically). Also, reported economic growth is mostly smoke and mirrors at the moment. The reported 5.7% Q4 GDP growth is likely to give way to Q2 and Q3 2010 growth in the 1% to 2% range, given the weak final demand components of the Q4 number. As you will recall, Q4 GDP got a huge assist from inventories declining at a slower rate, adding an estimated 4.4% to the final number. History indicates that subsequent quarters show punk growth when over half of GDP growth is coming from inventories.
In fact, there have been 9 quarters since 1970 in which GDP grew by at least 3 percent and at least half of the growth was due to inventories. While inventory spikes make for big growth numbers (average growth in the 9 quarters was 6.6%), average growth in the subsequent quarter averaged only 0.9% and only 1.6% in the second quarter following the blowout number. Weak growth numbers in the next few quarters will likely make current earnings forecasts overly optimistic, which will, in turn, pressure the stock market (It is possible that Q1 will come in fairly strong if the inventory swing hasn't quite played out).
One last indicator that the market is due for a further decline, or at least a relatively long period of sideways chop - the "we-can't-find-many-good-companies-at-great-prices" indicator is flashing at us. As many of you know by now, we do not do market timing. Rather, we look at risk levels in the market as context for our bottoms up, one-company-at-a-time, portfolio construction. It is currently taking us quite a bit longer to put new money to work in our client portfolios because we are just not finding that many good companies at great prices at the moment. Our price discipline held us in good stead in 2000-2001 and again in 2007-2008; we would expect it to prove beneficial once again in 2010. Meanwhile, we recommend continuing to treat the market as high risk, and plan accordingly...
