Are stocks turning bearish or is this the beginning of a post stimulus normalisation

On 29th January, in Ben Bernanke’s final FOMC meeting as Chairman of the US Federal Reserve, the Fed announced a continuation of tapering to the tune of an additional $10bn per month, bringing the total monthly purchases by the Fed from $85bn in November, to $65bn.

The market expected this, of course, and much of the decision was already priced into the markets.

So why then in the last 10 days have we seen a broad sell off in the financial markets and is there more to come?

The FTSE 100 has fallen close to 7%, suffering 10 down days in the last 11, a run not seen since November 2011 when the FTSE suffered 12 down days in 13, falling a total of 8.1% in the process.

Comparatively, the Dow Jones and Dax have also suffered similar falls of 7%, whilst the broader S&P 500 has fallen 5.8%.

The FTSE 100, Dow Jones and S&P 500 are all trading at fresh three-and-a-half-month lows.

So with stock markets falling and investors reducing their risk, where is the cash going?

Take a look at 10-year US Treasury yields below. They have started falling again, having hit 3% at the end of last year, and are now trading at 2.6%.

The correlation between stocks (Dow Jones in red) and US bond yields (US 10-year yields in yellow) echoes a return to market normalisation post-emergency measures, post central bank support, post QE. This is welcome and helps to make the market more somewhat predictable going forward.

But have certain features of the market within the last month highlighted danger signs? I think so.

The game changer has already started

First and foremost, let’s remember what many people called the game changer – the retraction of stimulus measures from the Fed.

Ben Bernanke maintained in his last FOMC meeting that taper is effectively on auto pilot; setting market expectations for a continued withdrawal of monthly asset purchases progressively throughout the year.

This was no surprise, of course and, given the fact that most economic indicators have pointed north on a consistent basis, tapering has made sense. In effect, investors felt somewhat comfortable that perhaps it was time for the markets to walk unaided once again.

Yet, what we have seen in the last few weeks has started to test the market’s confidence.

There has been a mini emerging markets currency crisis that has seen the Brazilian Real, South African Rand and Argentinian Peso all lose significant value.

China and the US are a concern

Then we have seen the two biggest economies in the world, China and the United States, both unsettle the market with some really poor indicators.

Chinese industrial production grew less than expected in December, whilst its manufacturing index (HSBC compiled) fell into contraction territory to mark the first deterioration in operating conditions in the manufacturing sector since July last year. Chinese PMI released this week also showed exports and jobs both shrinking.

In the US, we have seen some truly shocking data this week…

New orders fell by their steepest amount since 1980, whilst ISM fell to its lowest level since May last year and also suffered its sharpest drop since May 2011.

Optimistic investors carry the hope that perhaps this negative turn in data has been created by a knock-on effect from the Polar Vortex, which paralysed much of the US into a deep freeze, hurting consumption and output. There is certainly validity in this argument but as investors, are you willing to take the risk that the numbers are starting to tell you a different story?

US earnings disappointment

Add to the above is the fact that this earnings season has been far from a walk in the park. Apple, Google, Amazon, JP Morgan and even McDonalds all saw negative market reactions to their earnings.

Does this mean that these companies are in a bad place and are now unsafe to invest in? No.

Does this mean that market expectation is getting ahead of itself? Absolutely.

Is this just normalisation?

Let me bring this article back to the key premise. I have said this a few times before and feel it’s pertinent to reiterate: 2014 will be the year when investors will ask themselves if current stock market levels are a fair reflection of the risk that perhaps economic activity is not as strong as people think, that companies are heading into the new year with a degree of relaxation (as opposed to pessimism) and that we are all ready for the Fed to reduce stimulus.

Align that question to this simple fact: the FTSE, Dow Jones, S&P and DAX 30 have all rallied (aided by caffeine-like central bank stimulus) 42%, 59%, 72% and 97% in the last two-and-a-half years.

So this correction is a bit overdue and, when taken against the background of changing market dynamics of the past month, is absolutely understandable.

Friday payrolls could be the key

The markets historically are bullish between mid-February and April too, so perhaps from a cyclical perspective there is a case that buyers will start to emerge in the next few weeks.

US Treasury yields have found support at 2.5% previously and they are nearing this level. But beware Friday’s US jobs report.

The best thing that can happen to the markets right now is a strong jobs report. That would help to convince the markets that perhaps the last data we saw was weather related and the heartbeat of the US economy, its labour market, remains on the mend. And, it could trigger bargain hunters to enter the fray.

A weak jobs report could be dangerous, however, and would immediately throw the pressure on Janet Yellen, who addresses the House Financial Services Committee and Senate Banking Committee on the 11th and 13th of February. In that meeting, the markets will closely be watching what she says.