Here It COMES! (by Market Sniper)

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Keeping fully in mind that NOBODY knows what happens next as well as the Zurich Major Axiom 4: On Forecasts..Human behavior cannot be predicted. Distrust anyone who claims to know the future, however dimly. Nobody has the foggiest notion of what will happen in the future. Nobody. Never lose sight of the possibility you have made a bad bet….I do recommend that you take a look at ALL the Zurich Axioms at your leisure. They can be found here.  

Or in the immortal words the great Yogi Berra: The future ain't what it used to be. That being said, making predictions is so much fun, I cannot resist doing it. I think predicting the future is hard wired into us as a specie. What we CAN do is take a look at probabilities about the future and attempt to come to some idea of what the higher and lower probabilities of what happens next to be. That is what I will attempt to do with this post. These are my views and observations.

The Immediate Market Landscape

First of all, what to make of the pre-election rally? The markets were pricing in the potential of a Romney victory. Right up to the election results, the polls were telling us that the election was about to be a squeaker with a small margin of victory for either candidate. This caused a knee jerk reaction to the upside. Once the results were known, the market then started to price in what the result would mean going forward and the market does not like what it sees.

The fiscal cliff: Now that the election is over, the market is focused on the much ballyhooed fiscal cliff, I would like to address that first. For those few who live under a rock, this what will happen on December 31, 2012 unless Congress takes action prior to that date (very low probability). 1) The Bush tax cuts are history. This would be the largest tax increase in one fell swoop in United States history. Also gone are the payroll tax cuts and 2) massive cuts (actual, real cuts!) in federal government spending. This was a "compromise" arrived at 3.5 long years ago as a "temporary" measure. For 3.5 years, it has not been re-visited.

We now have a lame duck Congress which will also be reluctant to act pushing any further real work on this into next year. Due to the election results, the Obama Administration has taken it as a mandate to raise taxes and raise them substantially. Now if you think that the Republican House is going to roll over and play dead on this issue, you had best think again. When you are as dead as the Republicans are right now, how do you fight back? You try to kill the other guy, now you are both dead. But then you can always say you were dead first so it is the other guy's fault. We are dealing with career politicians here so the result can be predicted with a fair amount of accuracy. Will there be a retroactive solution long after the first of the year? It could well be the case, but by then the damage will already have been done. What damage you ask? Let me ask you this. You are sitting on a large portfolio of stocks.

A lot of blue chips and dividend paying stocks. Your portfolio, over the course of the past 3.75 years (more on that later), has increased substantially. You are now faced with the very high probability that capital gains and dividends will be, after December 31, 2012, taxed at a substantially higher rate. What would you, the prudent "investor," do? Most of us do not have a huge portfolio of stocks we have held for long term capital gains except perhaps in our retirement accounts. Individuals do NOT move markets, institutions do. Broker-dealers are sell side market participants for the most part. Who are the buy side participants? They are the market participants who bring capital to the market.

Typically, they are the pension funds, mutual funds, insurance companies, institutional investors and hedge funds. These are the participants who move markets. What would you do right now if you were in charge of such funds? We have the high potential for a stampede towards the exits due to the virtual certainty of much higher tax rates including capital gain and dividend taxation. Then we have the debt ceiling. Not much is being said about this at the present moment but we are rapidly approaching that ceiling. Remember the last time this was "dealt" with? Congressional deadlock plunged the market. That deadlock is what created the fiscal cliff we now face! You can keep track of that debt clock right here.

In summation as to the current market landscape: I see nothing here, short of some kind of Congressional kick the can into next year scenario (low probability) that avoids heavy, very heavy selling into year end. I do not look for any kind of year end, Santa Claus rally this year. The Market Santa most likely will be delivering coal by the ton for the stockings hung by the chimney with care.

Longer Term Market Outlook

I am anticipating a very major economic downturn in 2013 both here in the United States as well as globally.  Here I will just address the United States.

GDP: When year over year GDP falls below 2%, a recession follows 70% of the time within a year. 1st Qtr GDP was 1.9%. 2nd Qtr GDP was revised sharply downward to 1.25%. 3rd Qtr GDP was the same as the second quarter when removing government spending. Now, let's remove the other 30% probability of no recession. FACT: the GDP numbers coming out of Washington DC are gamed. Let me explain how that is done. There are five different federal agencies that come up with the inflation rate. Each uses different methodologies to arrive at that number.

When the GDP is calculated, the average number is not used. The mean number is not used. What is used is the lowest number! When GDP is calculated, one input is the inflation deflator. The lower that number, the higher will be GDP! John Williams over at Shadowstats does yeoman's work in debunking federal government statistics. According to his work, GDP is actually negative. The economy is shrinking. 

The Philly Fed Survey: This survey measures U.S. manufacturing and has averaged +41 in the three months preceding each of the last five recessions. Last month, it dropped to +24!!!

Negative Earnings Outlooks: The ratio of negative outlooks on earnings vs. positive is currently at 4.3 to 1! This is the most bearish earnings outlook ratio since Q3 of 2001!

Effect of Taxation on P/E's: As the Obama Administration has made abundantly clear, taxes are about to go up and not by a small amount. If you are a dividend type investor, to maintain your yield after taxation you will demand a lower price when you buy a dividend stock. This will also combine with the negative earnings outlook to shrink PE's from their current, historically lofty heights for a secular bear market. Based on this, stock prices will head lower.

At this point, we should take a short and cursory look at the market technicals and market cycles. As many realize, market tops are very much different than market bottoms. Market bottoms tend to be events characterized by "V" type price action. Market tops tend to be a process. It is a very rare occurrence when you get a blow off spike top in over all markets. Not uncommon in individual equity issues but rare for the over all stock market.

Since the June low of this year, what does the chart tell us? It shows there have been three attempts to form a higher recovery high. Each attempt, the high was lower than the last attempt. It is basic technical analysis in identifying trend. In an up trend, you need to see a series of higher lows as then the highs will take care of themselves. In a down trend, you see a series of lower highs. The lows will also then, take care of themselves. This is now what we are seeing, a series of lower highs. That is the very definition of trend. And finally, a thought or two about market cycles.

When we speak of bull and bear markets often the term "cyclical" and "secular" are attached. One cyclical bear market and one cyclical bull market comprise the normal run of the mill market cycle and tends to last a total of five years. Historically and broadly speaking, the cyclical bull's duration is around 3.75 years with the cyclical bear lasting 1.25 years. The cyclical bull averages gains of approximately 150% from trough to peak. In the cyclical bear, the average decline is 30% from peak to trough. When you do the compounding, this means the cyclical bear wipes out more than half of the gains of the preceding cyclical bull market gains.

These "averages" hide another source of variation which is where are they in the context of what secular cycle? For more than a century now you will find that market valuations have moved in very broad advancing and declining phases with each phase or cycle lasting about 17 to 18 years. For example, stocks moved from extremely low valuations in 1947 to very high valuations by 1965. Within this secular bull cycle, each cyclical bull market produced higher and higher valuations after each cyclical bear market within it. Conversely, the period from 1965 to 1982, valuation multiples went through a long contraction.

Each cyclical bear market bottomed out at lower and lower valuations. The effect of these longer valuation waves is that in the secular bull market, the cyclical bull tends to be longer and more rewarding and the cyclical bear markets tend to be shorter and less damaging. Conversely, in the secular bear market (which we are in now), the cyclical bear markets tend to be longer and more violent where as the cyclical bull markets tend to be shorter and less rewarding. Based on this, this cyclical bull market is very long in the tooth. A further word about short term cycles within the cyclical bull/bear. These are circles on a calendar based on confluence of short term cycles. When calling for a cycle low, you must be able to distinguish two types of lows. A price point in the market that you can go up from or a price point that you drop down into.

The same distinction should be made for a cycle high. It can be a price point you go up into or a price point you drop down from. This type of short term cycle work cannot give you those price points! They are merely time point on the calendar for  heightened awareness pn upir part which perhaps can be measured with other tools you use. A good example of this could be Tom McClellan's (of the McClellan Market Report, an excellent publication) call for some kind of cycle top in the spring of 2013. Does this mean an ES reading of 1500? Or does it mean that after seeing 1050, we then see 1200 prior to a further drop? Again, he does not know, I do not know nor does anyone else know the answer to that. Be careful attempting to apply cycle work to price points. It is a trap. I would suggest you use other technical tools to attempt to devine the answers to that question.

In conclusion: For the Chinese, 2013 will be the year of the Snake. For us, it appears it will be THE Year of the Bear. I will be trading it accordingly. Again, these are merely my thoughts and observations. Always use stops because being wrong is not an option. Staying wrong is! Hope this helps.

Yours in the never ending search for the trading edge.-The Market Sniper

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