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After the QE3 'Sugar Cube,' SPX Declines

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Also, sectors decouple: Witness the Dow Jones Transportation Average and the Dow Jones Industrial Average.

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Reminding us of the current equity market is an anecdote about the Sport of Kings that took place in London:

An American race horse owner, while parading his entry in the paddock just before the event, fed the horse what appeared to be a white tablet. Noticed and challenged by an English track official, Lord Marlboro, the American was informed that his horse would have to be disqualified. Protesting vehemently that he only gave the horse a sugar cube, the owner popped one into his mouth and offered Lord Marlboro a cube as proof. The English official tasted and swallowed the cube. He agreed with the owner that it was a harmless sugar cube and waived the disqualification. Just before the race horse was to enter the gate, the American signaled his jockey, instructing him to keep his horse clear of trouble near the start and try for the lead early since his horse was sure to win. "In fact," he told the jockey, "Only two have a chance to beat our horse." "What two?" asked the jockey? The American owner replied..."Me and Lord Marlboro!"
-- Anonymous

I recalled the "Me and Lord Marlboro" quip over the weekend as I prepared to journey to Keeneland Race Track this week to speak at a Raymond James function. For those that do not know about Keeneland, it is a thoroughbred horse racing facility and sales complex located in Lexington, Kentucky. It is also known for its reference library on the sport, which contains more than 10,000 volumes, an extensive videocassette collection, and a substantial assemblage of photo negatives and newspaper clippings about horse racing.

This "Me and Lord Marlboro" reference is not an unimportant observation since the stock market was fed a "sugar cube" a few weeks ago by the Federal Reserve in the form of QEternity! That "sugar cube" fostered a vault in the equity markets that left all of the sectors I follow, as well as the NYSE McClellan Oscillator, well overbought in the short-term. As stated at the time, there are two ways such an overbought condition can be corrected.

First, the equity markets can trade sideways, in a tight trading range, while the overbought condition is corrected. Or secondly, markets can pull back to a support zone to alleviate the overbought situation. In the current case that would be 1400 – 1422 for the S&P 500 (INDEXSP:.INX).

Last week, the tight trading range option was violated as the SPX declined to 1430.53, which was just slightly above my 1400 – 1422 support zone. The QE3 market surge came on top of an already strong rally that began on June 4. The nearly four-month old rally of about 16% has left 90% of portfolio managers (or PMs) underperforming the SPX. As year-end approaches, this underinvested crowd is now staring at not only performance risk, but bonus risk, and ultimately job risk. Indeed, just pull up a chart of the SPX and think about all of the underinvested participants that are not keeping up with the "Dow Jones" as they approach year-end performance report cards.

Manifestly, it seems like everybody is unhappy. To use the quote, I referenced a few weeks ago from Merrill Lynch's legendary strategist Bob Ferrell:

Money managers are unhappy because 70% of them are lagging the S&P 500 and see the end of another quarter approaching. Economists are unhappy because they do not know what to believe: This month's forecast of a strong economy, or last month's forecast of a weak economy. Technicians are unhappy because the market refuses to correct, and gets more and more extended. Foreigners are unhappy because due to their underinvested status in the US, they have missed the biggest double play (a big currency move plus a big stock market move) in decades. The public is unhappy because they just plain missed out on the party after being scared into cash after the crash. It almost seems ungrateful for so many to be unhappy about a market that has done so well... Unhappy people would prefer the market to correct to allow them to buy and feel happy, which is just the reason for a further rise. Frustrating the majority is the market's primary goal.

Adding to the angst has been the Dow Jones Transportation Average (INDEXDJX:DJT), which has decoupled from the Dow Jones Industrial Average (INDEXDJX:.DJI). Verily, since the June 4 low the industrials are up roughly 11% while the transports are flat. This decoupling has become even more noticeable recently, causing many pundits to suggest there is a big decline coming for the Industrials. Last week Mark Hulbert, in his MarketWatch column, elaborated:

The transports, as virtually everyone who is even slightly paying attention already knows, are seriously lagging the Dow industrials. It is widely assumed that this bodes ill for the stock market. But I am not so sure. A careful market analysis of the last three decades suggests that the Dow Jones Transportation Average is not the leading indicator that so many think it is.

Now many argue that the transports are a leading indicator because if companies are doing well the transports will benefit from higher volumes to carry those goods to market. Others will opine that our economy is more service-based, and not as manufacturing-driven as it used to be, so the transports don't count. As an avid believer in Dow Theory, I am always watching the transports. Yet, the recent weakness, at least to me, is not yet concerning.

I have commented that I think much of the weakness is attributable to the railroad stocks, which have been affected by the weather. First, it was the drought that hampered grain shipments; and then it was Hurricane Isaac. The "rails" have roughly 23% of their revenues tied to coal and grain shipments, so ex-coal and grain volumes are up around 2% quarter to date. The airlines have also come under pressure as fuel prices have risen. Regrettably, it is going to take a little longer before we see if the transports' weakness is a one-off thing, or a more meaningful event.

Interestingly, Mark Hulbert concludes:

But here was where the real shocker came in: The correlations that I did discover for the Dow transports were inverse. In other words, the stock market over the last three-plus decades tended to perform better following periods in which the transports were weak rather than strong.

Of course, this industrials and transports discussion leads to thoughts about Dow Theory. Therefore, it would not surprise me to see the transports break below their June 4 closing low of 4847.73 while the Dow stays above its June 4 closing low of 12101.46. That would represent a downside non-confirmation and should result in a re-rally for the equity markets. For the record, to render a Dow Theory "sell signal," at least by my method, would require both averages to close below their respective June 4 closing lows.

The call for this week: Mark Twain once remarked, "October, this is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August, and February." However, if the typical presidential election year trading pattern continues to play, after a pause/pullback stocks should trade higher (see the below chart). And this week is full of economic reports that could cause a pause/pullback.

This week, we get the global manufacturing data and the US jobs data. The wildcard, however, is Spain. The bulls are hoping that last week's Spanish budget proposals will pave the way for a bailout request by Mariano Rajoy's government. If so, it would be a step in clearing some of the uncertainty in the eurozone. Whatever the news, I don't think stocks will pull back much from here.

No positions in stocks mentioned.
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