The Red Flags of Impending Correction

Here is a good summary of why the correction I described in my previous post is very likely.

Following a week where the market has been churning at the highs and struggling to make any headway, a big gap down such as we saw this morning on a poor Retail number tends to concentrate the mind on some of the reasons for caution out there. Simply put, during March and April the market could afford to gloss over the negatives as long as stock prices kept marching higher due to some big catalysts that turned out to be better than feared: the Stress Test, earnings season, and economic data. Yet with these catalysts now largely out of the way, investors have been noticeably more aggressive in booking profits than they had been in the recent past, and shorts have finally had some success in taking down overextended stocks. Given this new sense of uncertainty that is starting to permeate the market after such a powerful rally, I thought it would be useful to summarize some of the possible warning signs that cautious investors are now citing as reasons for a near-term correction:

-- With the S&P now trading at 16x 2009 estimated EPS and 13x 2010 EPS, there are very few stocks that are legitimately "cheap" these days.
-- Along the same lines, the recent rally has already priced in expectations for continued better than expected economic and corporate news, suggesting that: a) disappointing data such as this morning's poor Retail Sales number has the capacity to negatively surprise the market, and b) that good news, such as INTC's "Q2 going better than expected" guidance last night, will show diminishing returns in terms of its capacity to surprise on the upside.
-- Companies have been rushing to bring debt and stock offerings to market over the past week. Beyond the simple matter of increased supply, this flood of offerings has the added implication that companies believe that now is the time to cash in on the rally in their stock prices.
-- The "garbage stock" rally we experineced over the past week or two, was a clear sign of froth in the market.
-- While substantial inflows of money into the market have lent a persistent bid to stocks in March and April, the other side of the recent rally has been the fact that short-covering has been a major source of upside fuel. This morning, Credit Suisse noted that the month-end data for April showed a solid drop in short interest across all market caps, suggesting that short-covering could become less of a supportive factor for stocks than it has been.
-- With the Stress Test and earnings season behind us, there is a distinct lack of catalysts entering the slow summer months.
-- On a technical basis the major averages are still overextended, although the recent selling has alleviated this somewhat, with the S&P 500 facing formidable resistance near 940-950 (its Jan high and 200-day sma).
-- More broadly, the trauma inflicted on the credit markets, the global economy, and particularly the U.S. consumer over the past 9 months, when combined with a degree of government intervention in the economy that we have not seen since the 1970s (many would argue the 1930s), does not augur for a V-shaped economic recovery. In other words, those 2010 estimates are still too high and need to come down.

Of course, the bulls will continue to argue that recent economic data suggests that the economy has bottomed, or is in the process of bottoming. The idea is that 2009 has already been written off, and that you have to be fully invested for when the real recovery begins in 2010. This argument implies that any correction will be of a short-term nature, and any declines will be bought.

The major averages were overdue for some profit-taking after running 30-40% off the lows in an almost straight line, so this week's minor sell-off should not be blown out of proportion. Yet the bottom line is that correcting stock prices no longer allow investors to ignore bad news such as this morning's Retail data, so in terms of understanding where current market sentiment lies, it's worth knowing what the arguments for caution are as we head into the summer. Selling in May and going away may not be such a bad idea.