Correction Looming??

What say yee in 2014? Thanks to Arthur Cashin and the Trader’s Almanac we can see that the first day of any year is not much of an indicator but the first five days have a very good track record. That is, if the market is higher. The track record of a down start is a bit spottier.

According to the very helpful Trader’s Almanac, the last 40 times the market rose in the first five days, it closed up on the year 34 times (85%).  – Cashin

We were struck by a statement out of the International Monetary Fund (IMF) this week that 1930’s style debt defaults are likely. The following is a good portion of the article which outlines approaches governments may need to take to counteract the large levels of debt. High on their list is inflation.

Many advanced economies are likely to require financial repression, outright debt restructuring, higher inflation and a variety of capital controls, a new research paper commissioned by the International Monetary Fund (IMF) has warned.

The magnitude of today’s debt in Western economies will mean fiscal austerity will not be sufficient, Harvard economists Carmen Reinhart and Kenneth Rogoff said in the report, as policymakers continue to underestimate the depth and duration of the downturn. 

“It is clear that governments should be careful in their assumption that growth alone will be able to end the crisis. Instead, today’s advanced country governments may have to look increasingly to the approaches that have long been associated with emerging markets, and that advanced countries themselves once practiced not so long ago,” they said.

The economists suggest that there are five different outcomes in dealing with this debt and highlight a “prototype” recovery period from their previous research. Economic growth is discounted as being too rare by both economists and austerity packages (as seen in Europe since the financial crash of 2008) are deemed as being insufficient. Instead, the size of the problem suggests that debt restructurings would be needed, they add, particularly in the periphery of Europe. The solution they propose, based on a typical sequence of events in history, shows some combination of capital controls, financial repression (like an opaque tax on savers), inflation, and default.

“In light of the historic public and private debt levels…it is difficult to envision a resolution to the current five-year-old crisis that does not involve a greater role for explicit restructuring,” they said. – CNBC 01/03/2014 Matt Clinch

From an interview in Barron’s this week comes Ned Davis’ opinion on the year ahead. Ned Davis is the head of Davis Research and is very well respected in the street for his take on markets.

However, we’ve looked at all the bear markets since 1956 and found seven associated with an inverted yield curve [in which short-term interest rates are higher than long ones] – a classic sign of Fed tightening.  Those declines lasted well over a year and took the market down 34%, on average.  Several other bear markets took place without an inverted yield curve, and the average loss there was 19% in 143 market days.  We don’t see an inverted yield curve anytime soon.  So, whatever correction we get next year is more likely to be in the 20% range.

Thanks to CNBC and Piper Jaffrey comes a further outline of the US Presidential Cycle where we can look for more hints as to what 2014 has in store. Last blog post we noted the Presidential Cycle. Here are some further tidbits on the cycle and what that means for markets in 2014.

More particularly, the second year of the cycle—the year when midterm elections are held—tends to be volatile, with substantial pullbacks, corrections or outright bear markets not at all uncommon. The typical return during such years is just 5.3 percent, or barely half the norm.

Piper Jaffrey points out that since 1930, pullbacks during midterm years have averaged 17 percent.

“We suspect 2014 may be a good, but not a great year for the broader market (high single-digit to low double-digit return), with a higher level of volatility, and that relative strength-based sector exposure will be key to outperformance.”

Since 1945 the S&P 500 has posted 21 annual gains of more than 20 percent. The average gain the next year was 10 percent, with the index up 78 percent of the time.

However, every one of those “good” years saw drops of at least 6 percent and up to 19.3 percent. Four of those years triggered new bear markets.

So it seems that just about everyone is looking for a bumpy year ahead with a definable correction along the way. On an anecdotal basis we were in a small café in northern Georgia just west of the “middle of nowhere” when we heard two ladies chatting about the stock market. The one woman assured the other woman that there is a correction coming. That confirms it. Exactly everyone expects a correction this year. They could be right but we have learned that the market usually doesn’t work that way. The market has a habit of making a fool out of the most people that it possibly can. Could it be that the correction never comes? It is also possible that the correction is deeper than most expect. Always the contrarian and looking to second level thinking.

Emerging markets have suffered in the first two trading days of the New Year. The Emerging Markets ETF is down 4% in 2014. Thailand’s market is bearing the brunt and Turkey is off to a poor start. The end of QE brings money back into safer assets like the US 10 year as it flows out of stocks and hot money destinations like emerging markets. Keep an eye on emerging markets like Turkey and Thailand.

The 10 year is looking to bust out over 3%. The holiday may have kept the stock market in line. Seminal changes tend to occur on the calendar. Oil is down 8% over the last 4 trading days and gold is looking to bounce off of lows. Tax loss selling may be responsible for pushing gold to recent lows and bargain hunters look to be jumping in here. We certainly have oil, gold and the 10 year on our radar. We suggest you do the same.

Remember that the turn in the calendar in 2014 may entice managers to raise cash levels early on in the year as to not suffer any outsized losses at the start of 2014. A large loss early in 2014 would make for a tough slog all year. However, missing out on some upside early on in the New Year would be far easier to make up for on the performance side. That could make for a sloppy January. The Fed is back buying in the open market next week so that could help provide some support. They did not participate in the first two days of 2014.

Here is to a happy, healthy and prosperous 2014!!

To learn more about us and Blackthorn Asset Management LLC visit our website at www.BlackthornAsset.com .

A pessimist sees the difficulty in every opportunity; an optimist sees the opportunity in every difficulty. – Winston Churchill

I learned that courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear. – Nelson Mandela

Disclosure: This blog is informational and is not a recommendation to buy or sell anything. If you are thinking about investing consider the risk. Everyone’s financial situation is different. Consult your financial advisor.

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