Watch out for the snow cliff

Everyone is aware of what a fantastic year it was for the US stockmarket in 2013.

The S&P 500 was up 30%. So now it only makes sense, given how consistent last year’s rally was, that people are on the lookout for a potentially significant correction – and some are even again suggesting a lasting top in the market.

In looking for the vulnerability in the market it is always crucial to understand why the market was so strong in the first place. The most common belief is that historic quantitative easing by the Federal Reserve is the main driving force of the rally and, while stimulus is now on a diminishing path, the residual bond buying will continue to support the market for a time. This is a perfectly correct view to hold, but only to a point. The US equity markets are of such a scale that whatever stimulus funds are eventually finding their way to the stockmarket are certainly supportive of the market, but they are by no means the dominating factor. There is something else going on.

As I have previously suggested, the real driver is ever-increasing corporate revenues and profits, which is, after all, the primary reason for investing in a company. The economic backdrop to the creation of these accelerating profits is far more complex and robust than just the Fed’s bond buying program. The world is a far more prosperous place today than the consensus of the past few years thought it would be. Not only does this mean far greater profitability than was anticipated, but also that the market has a fair degree of catching up to do in terms of sentiment.

The potential reasons for a major correction – a stockmarket downturn that would inevitably and immediately be mirrored on our own ASX 200 –then probably rest more with classic economic risks than with the process of Fed “tapering” (reduced money printing). Tapering will continue and the bond-buying program will be completely wound down by the end of the year, but there is room within the year for the Fed to skip a program reduction at the odd meeting. It will do this if there is any sign of economic reversal in what has so far been a quite strong private sector-driven “Main Street” recovery.

So while there are still calls to sell stocks due to “tapering”, we have already seen at the first round of “tapering” that the market can rally. Indeed the Dow has been testing new highs over the last week.

This January rally could be a continued short-term pattern, as people hold off buying ahead of a Fed meeting, but then due to ongoing strong profitability have to buy stocks in any case after the meeting. The potential risk then for “tapering” to cause a correction, is low.

When we turn to the broader fundamental picture, we have already seen significant re-acceleration in China, Japan seems to be making significant headway, and even the UK and Europe are clearly on the mend. There has been some dislocation in Latin America, but again, in the main, things appear to be back on a more reasonable course toward sustained economic growth. There will always be the potential for any of these or other economies to experience a slowdown, but a severe economic downturn outside of some form of natural disaster is unlikely at this stage of accelerating global growth. Having said that, we have in fact just seen a form of natural disaster unfold in the US.

While the run of US data right up until the end of last year has been above consensus and encouraging (GDP at 4.1%), there are just a few cracks beginning to emerge.

Really, it is about the weather. While we endure our extreme heat in Australia, it would be understandable to think it was just cold in the US over recent weeks. However, this was severe weather, where in some cities you were not even allowed to drive your car unless it was for an emergency. Close to 20,000 flights were cancelled. Amtrak cancellations, and general highway chaos will have a profound impact on the economic data for January, and we will only begin to see this data downturn in February.

This is the “snow-cliff”. The economy was most likely more seriously impacted by the deep freeze than it was by even last year’s partial government shutdown. This was not just a government slowdown. This was an entire nation virtually stopping for several days to a week. The great majority of industry and businesses were at a standstill as workers either could not work, or could not even get to work. Florida and California were spared, but the extent of the deep freeze over most of the country was extraordinary.

This is not to suggest the underlying economic expansion is at risk, or that we should be overly concerned regarding the now nearly six-year bull market. There is a significant risk, however, that investors will be momentarily stunned as the run of economic data falls off a cliff. We have already had a warning shot across the bow with last week’s employment data. That poor number has already been blamed on the cold weather, but the worst weather was yet to come. During the deep freeze people were more concerned with keeping their home and family warm than they were with work or other productive purposes. The intensity of this relatively brief slowdown has the potential to sow seeds of doubt about the overall economy.

There will be debate about whether the declining data is just about the cold weather, or is there something more fundamental being covered over by the snow and cold story? When combined with caution about further “tapering”, this then does create a scenario for some form of correction in the stockmarket. This will be a correction driven by the “snow-cliff”, rather than “tapering”, as the rally has indeed been driven by profits, and profits will have taken a big hit in January.

So a true vulnerability exists in the short to medium term, one that could cause the Fed to skip “tapering” further at the first meeting of the year. Paradoxically this could then be seen by the market as another reason to sell. “If the Fed is concerned, we should be too”, could become a flavour of the month sentiment factor in February as the poor January data emerges.

Let us hope so, as we are living in the midst of one of the greatest bull markets in history, and a correction would be a great opportunity!

A lot of people are suggesting caution as we are at the top of the range of the last 10 years, but I tend to see us as being at the bottom of the range of the next 10 years. There is a growing surge of prosperity around the world that is undeniable, and price earnings ratios are barely above their long run averages, meaning exuberance has barely begun to emerge in this bull market.

If we begin to see the suggested “snow-cliff” effect on US data in coming weeks, then we perhaps we will get a significant correction, one to be taken advantage of.

Clifford Bennett is Chief Economist, brushTURKEY clifford@cliffordbennett.com.au.