Stock Market Correction Ahead?

In my May 22nd post, I talked about the S&P 500 Index approaching its 200-day moving average, an important level that would inspire confidence if the index could close above it on strong trading volume.  Well, the S&P 500 did close above the 200-day moving average on June 1st, but volume was lackluster, and has remained so ever since.  To us, the low volume suggests a lack of conviction on the part of investors, as well as a potential exhaustion of the monster rally off the March 9th lows.  This monster rally has been driven by confidence that massive stimulus by the world's central bankers and treasury authorities, on a scale never before seen, has averted a systemic collapse of financial markets and has produced the "green shoots" of economic recovery.

While we agree that the financial system has stabilized - for example, credit markets have improved to pre-Lehman bankruptcy levels, and the banks have successfully raised billions of dollars of capital - many critical questions remain unanswered, casting doubt on the sustainability of the equity market rally.  Market action over the past two days suggests the answer to one of those questions won't be pretty - the question being, what happens when the Federal Reserve eases off the gas pedal? 

Since the financial crisis began, the Fed, Treasury, and central banks around the world have devised ever more ambitious plans to revive the credit markets, including guarantees, asset swaps, and outright purchases of debt.  Since September 2008, the Fed has increased the monetary base by almost $1 trillion, an amount that dwarfs the increase following 9/11 by a factor of 10.  All of this stimulus and printing of money has led to fears of hyperinflation.  The bond market has suddenly begun to question who would be willing to buy the $2 trillion in debt to be issued by the Treasury over the next twelve months, sparking a rise in Treasury yields that threaten to derail the "green shoots".

With interest rates rising and investors bidding up the prices of traditional inflation hedges, such as oil and other commodities, it was disclosed over the weekend that the G8 is exploring ways to scale back central bank support of the markets.  In addition, the Fed appears reluctant to expand purchases of mortgages and Treasuries.  Predictably, stocks sold off sharply to start the week.  The bottom line: for much of the global credit market, governments are the only game in town.

We continue to believe that stocks have enjoyed a massive rally within an ongoing bear market, expecting at least a mild correction to begin soon.  For the markets to advance much higher from here should require substantive signs that point to growth, not merely a slower pace of contraction.  We see three important events to watch over the next several days: stock option expiration this week, the Fed meeting next week, and end-of-quarter maneuvering by money managers.  Today's S&P 500 close at 912 places the index right at the downward-sloping 200-day moving average.  A close below 900 could provoke more selling, while a move above 950 could spark a run higher as investors get a dose of "performance anxiety" into the June 30 quarter end.