Week End Perspective: April 11, 2014

As bad as Thursday’s sell-off was for momentum stocks, it was preceded by a two-day rally. Biotechnology, solar, and some Internet names fell to new lows for the year, which technical analysts take as a signal of further weakness. Fortunately, the previous rally helped to soften the impact and mitigating some of the bearish sentiment.

More worrisome was that the broader market joined in the selling yesterday, and on high volume, which could portent further weakness ahead. In particular, financials broke sharply lower, with J.P. Morgan (JPM) and Wells Fargo (WFC) sliding about 3 percent, in line with Bank of America (BAC) and about 1 percent worse than Citigroup (C). This drop is concerning for two reasons. One, JP Morgan and Wells Fargo have been propping up the financial sector and not breaking down like Bank of America and Citigroup. Second, financials is the second largest sector in the S&P 500 Index. If this sector weakens, the broader market will most likely follow.

Both JPM and WFC reported earnings today and the picture was mixed. Wells Fargo delivered a solid earnings beat that sent shares up by more than 1.3 percent in early trading. J.P. Morgan missed analyst expectations and shares fell as much as 5 percent; through mid-day, it remains down over 3 percent.

Overall, JPM weighed more on the sector in the morning and financials were trailing the overall market by a small margin, but were beginning to rally. The earnings results were notable because both banks suffered from lower earnings due to reduced mortgage refinancings. Wells Fargo’s mortgage loan originations fell from $109 billion last year and $50 billion in the prior quarter, to $36 billion in Q1. However, Wells Fargo also reduced its loss reserves, something banks do when credit conditions are improving. The overall picture appears bullish for the economy if growth picks up, but a mixed bag in the short-run as some banks struggle.

At this point, the sell-off in stocks remains an internal affair. That is to say, stocks are selling off because they are overvalued or investors decided to sell, but there isn’t a strong economic case for the drop. Oil prices barely dropped on Thursday and economic data has been solid of late. The worst information out this week was Chinese trade data and still emerging markets outperformed on Thursday.

The one economic change that may be affecting stocks is the Federal Reserve’s taper. The Fed can say it is keeping monetary policy loose since it is not raising interest rates, but on net it is tightening by ending the “extra loose” policy of quantitative easing. The slowdown seen in China and other emerging markets is a consequence of this policy. It was those markets, and in particular China, which saw immediate inflows of foreign capital when the Fed announced each round of QE. When the Fed announced the taper last May, the flows reversed and China experienced a serious cash crunch in its financial system. It has taken some time, but the effects of the Fed’s taper on financial markets may be finally hitting the U.S. market.

While investors may not like to hear it, the market is also overdue for a correction. Such an occurrence is healthy and will extend the life of the bull market.  The last one came in the summer of 2011, nearly 3 years ago. A correction here would be in keeping with history and would also be good for stocks. In the recent past, U.S. markets have gone four years without a big correction: in the mid-1990s and again in the mid-2000s.  However, the corrections that ultimately came were intense. The markets sank in 1998 due to the Asian Crisis. In October 2007, the stock market topped and then went into an 18-month bear market.

The wildcard remains China, where the government and central bank have refused to take action to stop the economic slowdown and instead say it is a healthy component of reform. Investors are still optimistic on China, expecting the slowdown to mean growth of 7.3 percent instead of 7.5 percent. Bad news out of China, or simply a reinterpretation of the current situation, could add fuel to the sell-off.

As for sectors, energy remains attractive. Energy stocks have corrected, but energy prices have held their ground. Utilities also have been barely dented by the selling. In a bear market, utilities fall less than the market, but they still can fall in price. As of today, utilities are still in a determined uptrend that goes back to the start of 2014. Not only is it a good sign for the utilities sector, but it is also a very good sign for the broader market.

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