Technical Breakdown

The U.S. equity markets feel very heavy right now. We say that in light of the warning signals we have been receiving over the past few weeks that a correction is on the horizon. It is our opinion that this anticipated correction started last week, with the markets showing their worst weekly performance of the year.

One positive in the face of this surly market action is that we have appropriately positioned our clients so that gains earned earlier in the year are protected and for some in the more aggressive accounts, we are showing marvelous gains for the month by investing in securities with an inverse relationship to the market.

We’ve been receiving calls from investors / prospects regarding the length and severity of this correction. While we are able to use probability to attempt to capture market direction, the length and severity of the correction is unknown at this time. Our view, based on our fundamental analysis, has been that any downturn in the market would be short lived and we are targeting a 5% to 7% correction for the S&P 500. Thus far we are down 3.6% from the highs hit on April 2nd. We liken the interpretation of our market models to a game of chess. One needs to plan five or six moves ahead based on the opponents’ next move!

Bottom Line: The market is in a downtrend and we will continue to remain bearish until the market tells us otherwise.

How the market speaks

There are a few indicators that we are watching now, but most important is our proprietary behavioral model. Our model will score within one of five basic market cycles. These cycles include “Extreme Euphoria”, “Greed”, Rational Market”, “Fear”, and “Extreme Panic”. Depending on where we are in the market cycle determines how aggressive our portfolio structure. Typically, the best time to be conservative is when we are falling from the Greed - Extreme Euphoria cycle as we are today.

Bottom Line: We will monitor this model daily and start to increase our bullish long exposure as the orange trend line starts to move higher. Until that time comes, we will remain bearish and defensive.

Treasury Yields

There has been a newfound sense of anxiety in the markets as it relates to the European debt crisis. More specifically, yields on the Spanish ten year sovereign debt has launched north of 6% as of the time of this writing. Conversely, yields on the German and U.S. ten year have fallen to 1.74% and 1.98%, respectively.

Also, there have been reports last week that borrowing from the European Central Bank jumped 86% in March vs. February indicating complications on the part of Spanish banks in raising money from the private sector. The cost of insuring Spanish government debt vs. default has hit a record high.

This places Spain center stage in the Euro drama that roiled the markets last year and does not bode well for equity returns should the Spaniards fail in their efforts to raise money to finance their government spending.

Put into perspective, the Spanish economy is the 12th largest economy in the world. If you combine the economies of the three European bailout participants that is Portugal, Greece and Ireland; it wouldn’t add up to HALF of the Spanish economy.

Simply put, the International Monetary Fund does not have enough money to bail out Spain and the European Central Bank may not have the stomach to purchase under-subscribed Spanish debt. That leaves us with the most likely outcome…default!

Spain is going to market this week to attempt to sell debt, so we will see how the risk appetite is for these instruments. Also, the IMF meets in the coming days to discuss further options.

We are not projecting a potential default on the part of Spain, but the situation there is increasingly troublesome and needs to be monitored. Until some sense of clarity materializes, we will keep our current bearish – defensive position in place.

Earnings Season

One quick observation. Google, Wells Fargo and JP Morgan Chase all reported strong 1Q12 earnings last week. All three sold off on the news.

Any further attempt by the equity markets to rally may be stymied by a problematic earnings season.

Market Volume

One more quick observation. Last week, the market had been selling off on higher volume and rallying on lower volume.

Pricing and volume action are not indicative of a market that wants to go higher.

Joseph S. Kalinowski, CFA