Friday, May 13, 2011

Storm Clouds on the Horizon

(Editor's Note: Paul Schatz, President of Heritage Capital, LLC, in Woodbridge, will be contributing to Fi$callyFit every Friday. Read his biography here)

Below is a familiar chart of the S&P 500 showing the various 4-8% pullbacks we continue to see. As I write this, the stock market is rolling over to the downside and it certainly has the feel of wanting to sell off more in the coming days. 

Rallies are getting shorter and choppier. If we do see more weakness, my initial take can be seen in blue and calls for a move below last week's low before resuming the rally.

Until proven otherwise, I believe this is just another 4-8% cleanse before moving higher. HOWEVER, as I have written about before here and included in my 2011 Forecast, I do not believe 2011 ends up hugely in the black. I think we "borrowed" some of that upside last year. 

My concerns now are growing, given that this entire bull market has been surfing a tidal wave of liquidity and the Fed is firm that the torrent will be turned off on June 30. Do I hear QE3?!?! I have serious questions whether the economy and markets can stand on their own two feet without major help (government assistance). 

I hope and pray Bernanke heeds the lesson learned in 1937 after the Dow rallied 400% from the 1932 low and all was sanguine in the economy and markets.  Back then, the government pulled fiscal stimuli, taxes were increased and interest rates were raised. Most people forget that the Great Depression Part II began with a surge in unemployment and a collapsing stock market. Only a shift to a wartime economy after Pearl Harbor did the U.S. begin the real recovery.

Last spring, as you can see below, we saw what happened when the Fed stopped pumping money into the system. Of course, Greece and the Flash Crash had something to do with it!

IF the stock market is in the process of building a peak this quarter, I think volatility will continue to increase through the end of June. We should see fewer and fewer stocks in healthy shape and more than a few key market sectors not behave well during rallies. I would also imagine that junk bonds and/or small caps would start to underperform, given how sensitive they are to liquidity.  In turn, that would set the stage for some unpleasantness (10-20% correction) during the third quarter.

Arguing against this theme is the fact that this is the third year of Obama's term, the strongest of the four year cycle where we have only seen one down year in the past 70-ish years. But as I mentioned already, I think the market borrowed some of the rally last year, which should have been a poor year according to the presidential cycle. 

In short, I am not ready to jump ship just yet. We are dancing close to the door, but I think there should still be some more upside after this little pullback exhausts itself in the coming week or two.

FYI, I will be on CNBC’s Worldwide Exchange from 5:30am to 5:50am on May 17.

Feel free to email me with any questions or comments at

Until next time…

Paul Schatz

Heritage Capital LLC

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