December 22, 2014

2015 to be a more challenging for stock market

The expanding disconnect between (rising) stock prices and (a weakening in) the real economy might be borrowing against future market gains. Late last week, as the markets fell, I argued that a year-end rally could emerge from the oversold.

Over the last two days a more significant rally than I expected has developed, possibly borrowing (or taking away) from any more seasonal strength.

Anecdotally, some observers who hated the market at last week's depths have turned unambiguously bullish now. I would argue that reward vs. risk (upside vs. downside) is now turning unattractive (for traders that have a time frame of 1-2 months).

I expect 2015 do be a more challenging year than 2013-2014. Valuations have risen quite substantially over the last two years as the disconnect between stock prices and the real economy has been stretched.

One needs only to parse through the domestic economic data that have been released this week (and have generally been ignored as a result of the spectacular climb in global equity markets).

First, the Markit flash services PMI was much weaker than consensus expectations (coming in at 53.6 compared with an estimate of 56.3 and to the prior month of 56.2). Importantly, the drop relative to consensus was driven by the weakest new orders print (53.4 from 55.6) in more than nine months. Input prices declined to the lowest level in mor ethan four years. Payrolls in December, says Markit, should be weaker than seen in recent monthly reports. And the rise in backlogs was at the slowest pace in six months. According to Markit, the manufacturing and services PMIs suggest that 4Q 2014 real GDP could drop below 2%.

Second, the Philly Fed Index also came in below consensus expectations (at 24.5 vs. 26.0E and from 40.8 in the prior month). Most components (including employment, shipments and new orders) were lower than expected, while inventories were at the higher end of estimates.

Though consumer confidence and retail spending have been relatively strong, the above weak reports are in line with the poor PMI report and present a mixed view of the trajectory of the domestic economy as we enter 2015.

Suffice to say, recent data suggest that the non-U.S. economies are also weakening and the chaos in Russia is raising additional risks to the downside.

Let's get back to the equity markets.

After trading like a drunken sailor over the last 10 days, I expect to reduce my activity and, as I suggested, gradually reduce my Value at Risk in the days ahead.