The Market Correction that Was?

Last week, the S&P 500 abruptly halted its months long grind higher finishing 1.0% lower while the Dow Jones Industrials managed a somewhat flattish performance.

The market appears to be sensing a softening in growth momentum (i.e. compared with January and February) as the first few March data points (U.S. manufacturing and non-manufacturing ISMs and ADP/BLS jobs reports) have printed on the lighter side of expectations.

There is now legitimate fear that fiscal headwinds of tax hikes and sequester spending cuts could have a larger impact in the second quarter compared with the first. With that, more red flags have been unfurled: Italy’s non-government, Cyprus, Portugal, China, commodity slump, North Korea, Iran and lower expectations of US growth.

So, where’s the market correction?  Why have stocks been so stubborn to retrace?  It’s all so profoundly difficult to understand or reconcile with a market sitting near all-time nominal highs.

However anxious we may be for a healthy correction, allow me to propose that perchance we had one already?  A market tweaking – one that struck while we weren’t looking?  Or, one that we weren’t looking for?  Whatever you want to call it (i.e. divisive divergence, rotating adjustment) we did have something – it was a correction without a crash.  A deep reflection of the many global uncertainties that surround us.

Look closely at what transpired last week. Healthcare, REITs, Telecom, and Utilities names all rallied, while Airlines, Networking, Steel, and Semiconductor stocks got hit.  This dynamic has been in place for weeks but most recently has picked up a lot of steam.  There is this seemingly one-off trend where money is moving swiftly to “safe haven stocks” leaving cyclical names in the dust.  In corrections past, investors would dump stocks wholesale.

On a year-to-date basis some of the worst performing stocks also happen to be cyclical stocks: (NYSE:ANR), (NYSE:BTU), (NYSE:CLF), (NYSE:FCX), (NYSE:JOY), (NYSE:POT), and (NYSE:WLT) to name a few. On the flipside, the bulk of the S&P 500's gain is attributed to stocks recognized as “safety issues”:  (NYSE:BMY), (NYSE:BRK), (NYSE:JNJ), (NYSE:KO), (NYSE:PEP), (NYSE:PM), (NYSE:T), and (NYSE:VZ).  From a fundamental or even historical perspective this sort of stock market nuance doesn’t make sense and it's one that should have investors big and small questioning the health of the economy and stock market in general.

Yet, in the end, we must remember that convention, fundamentals, historical standards and intuition will not help you navigate our current state of stock market action. We are in the midst of a never-tried global monetary policy “experiment” – it’s working for now but I shudder to think how it will eventually end up. Personally, I’m not preparing for an “Armageddon scenario” but am surely stepping aside waiting patiently for a better reason to be fully allocated to equities.

Regarding the Bank of Japan’s monetary policy and US Treasury rates: Treasury yields have plummeted over 25 basis points since early March driven by eurozone stability threats, disappointing economic data, and the most recent Quantitative Easing (QE) program announced by the Bank of Japan.  U.S. Treasury yields are now just 32.50 bps from their lowest point set on July 24, 2012.

The Bank of Japan’s policy initiative is powerful, increasing its monetary base an estimated $600 billion to $700 billion per year, combined with the purchase of $500 billion of Japanese government bonds, and the longer-term consequences are hazy at best.  Short-term, this “new money” entering the system will simply add to the old theme of too much money chasing too few bonds in the higher-quality space as the nominal difference between Japanese Government Bonds (JGB) and 10-year US Treasuries is currently trading at 116 bps.  This new demand source for the US 10-year Treasury could keep U.S. rates ridiculously cheap and potentially could have newfangled implications for the current Fed policy.