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'Dog Days' Stock Market at Perfect Point to Decline, but Don't Get Too Bearish

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Surprisingly, while most of the major indices look like they are rolling over to the downside, some of the recently shunned sectors appear to have reversed to the upside.

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The phrase "dog days" refers to the sultry days of summer. In the Northern Hemisphere, the dog days of summer are most commonly experienced in the months of July and August, which typically experience the warmest summer temperatures of the year. In the Southern Hemisphere, they tend to occur in January and February, in the midst of the austral summer. "Dog days" is also defined as "stagnation," so I think "dog days" is the proper moniker for last week's market action as all the markets stagnated! However, there is an upcoming "polarity flip."

Last week, I discussed the "polarity flip," whereby the sun's polarity will actually, well, "flip." An example would be if the magnetic fields of the North Pole and the South Pole changed places. Solar "flips" happen about every 11 years and coincide with dramatically increased solar activity causing sunspots, coronal mass ejections, and solar flares on the sun's surface. In turn, such increased activity, when directed towards Earth, results in shock waves of traveling solar energetic particles causing geomagnetic storms here on Earth. Interestingly, this solar "polarity flip" is about to occur, according to Yahoo.

While I am not a believer in astrology, there is considerable evidence that such events tend to have a measurable effect on a number of things. Accordingly (at least in an exhaustive study by the Atlanta Federal Reserve), shifting magnetic fields, and the impending movements in the various equity markets following those "shifts," can have a dramatic effect on investors, markets, electronic devices, etc. While that may seem far-fetched, the attendant 53-page report from the Atlanta Federal Reserve should give some clarity to a reference I made last Thursday about Arch Crawford's suggestion that solar flares do indeed affect investors' attitudes since they create geomagnetic storms. As written in the Federal Reserve Bank of Atlanta's Working Paper entitled "Playing the Field: Geomagnetic Storms and the Stock Market" published in October 2003:

"Explaining movements in daily stock prices is one of the most difficult tasks in modern finance. This paper contributes to the existing literature by documenting the impact of geomagnetic storms on daily stock market returns. A large body of psychological research has shown that geomagnetic storms have a profound effect on people's moods, and, in turn, people's moods have been found to be related to human behavior, judgments and decisions about risk. An important finding of this literature is that people often attribute their feelings and emotions to the wrong source, leading to incorrect judgments. Specifically, people affected by geomagnetic storms may be more inclined to sell stocks on stormy days because they incorrectly attribute their bad mood to negative economic prospects rather than bad environmental conditions. Misattribution of mood and pessimistic choices can translate into a relatively higher demand for riskless assets, causing the price of risky assets to fall or to rise less quickly than otherwise. The authors find strong empirical support in favor of a geomagnetic-storm effect in stock returns after controlling for market seasonal and other environmental and behavioral factors."

Perhaps, investors read the attendant Yahoo article last week and sold in anticipation of the solar "polarity flip." Whatever the reason, the result left the Dow Jones Industrial Average (INDEXDJX:.DJI) down 232.85 points (1.4%) for the week, while the Dow Jones Transportation Average (INDEXDJX:DJT) lost 172.06 points and the S&P 500 (INDEXSP:.INX) shed 18.25 points (1.07%). It was the first weekly loss for the Industrials in seven weeks and reinforced what I wrote in last Monday's letter. To wit:

"Personally, I believe what is shaping up is a giant false upside breakout pattern that would be confirmed by a close below 1700 on the SPX, and reinforced by a break below 1684. However, in this business stubbornness is a dangerous trait! Accordingly this week, and next, should tell us if my cautionary call, within the context of a secular bull market, is going to play."

And while last week was somewhat "telling," the SPX tested, but did not close below my key pivot point of 1684. So we enter this week still thinking it is "kiss and tell" time. In numerous missives I have given a plethora of reasons why the mid-July through mid-August time frame is the window for the first meaningful decline of the year to begin.

Well, it's now mid-August and earnings season is just about in the rearview mirror. Admittedly, earnings remain better than most expected with 62.9% of all reporting companies beating estimates (68% for the S&P 500), while 56.6% of all reporting companies beat their revenue estimates. However, with earnings season about over, there will be no upside earnings catalyst for the next few months. Nor will there be any catalyst from the Federal Reserve until their September meeting. And, while there could be some consternation out of the DC beltway about debt ceilings, continuing resolutions, and sequestration before Congress's early-August recess, hereto there will be a political void over the next few months. So I will say it again: We are at the perfect window for the first meaningful decline of the year, but it is likely within the context of a new bull market. Of course, that begs the question, why?

First, purchasing managers' reports from around the world are improving (including China) with global economic growth registering its best reading in two years. Second, conditions are in place to suggest a capital expenditure cycle is about to commence. Indeed, strong readings in the purchasing managers' index should compel corporate America to start spending money. And third, low inflation, a stronger dollar, and a faster-than-expected reduction in the budget deficit should allow price earnings multiples to expand. But even if PE multiples don't expand, stocks can still trade higher. Consider this: The SPX is currently trading at a PE multiple of 15.5x based on the S&P's earnings estimate for this year of $108.81. Next year's bottom-up operating earnings estimate is $122.43. If in 2014 the SPX trades at a PE multiple of 15.5x on that year's earnings estimate, it implies a price objective of ~1897. So even if we get the decline I have been looking for, do not get too bearish.

Surprisingly, while most of the major indices look like they are rolling over to the downside, some of the recently shunned sectors appear to have reversed to the upside. Just look at the charts of copper and coal, certainly two of the most hated industry groups out there. Take coal, as represented by the ETF Van Eck Global Market Vectors Coal (NYSEARCA:KOL). It looks to have bottomed and turned up (see chart).


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The call for this week: This morning the pre-opening futures are off sharply (-10 points at 6:00 a.m.). But, the envisioned pullback should be used for rearranging portfolios, and for buying, because such draw-downs are typical within the confines of bull markets (see chart).


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