Are The Bears Back?

As has been mentioned a time or two hundred in this space over the years, the primary purpose of our oftentimes meandering morning market missive is to identify the drivers of the market action. The thinking is that if we can understand why the indices are doing what they are doing in the short-run, we are unlikely to get "fooled" in the long run. So, before we embark on the final two installments of our "market math" message series, we thought it would be a good idea to take a break and explore the reasons behind yesterday's sudden and relatively violent dance to the downside.

So far in 2014, there has been a fair amount of intraday selling each day. When the calendar changed from 2013 to 2014, it was as if someone flipped a switch. Gone were the quiet days where the indices inched up slowly. Gone was the Santa Claus Rally. And gone was the environment where volatility was nowhere to be seen. In short, the sellers have been showing up each and every day so far in 2014.

A Changed Environment

It is also interesting to note that to date, the intraday moves have had little in the way of impetus. There have been no violent reactions to news items or headlines - just a steady diet of sell programs. And while the sell-algos have regularly knocked between 0.25 percent and 0.50 percent off the value of the indices in a few minutes, the bouts of weakness have been relatively short-lived.

The algos have clearly been quite active on the sell side each day. Yet, the bottom line is that the intraday selling has been met with buying. Whether the rebounds have been triggered by dip-buyers or simply trend-following programs trained to "go the other way" after a specific price target has been met remains to be seen. But the key takeaway has been that the negative intraday action had failed to have much of an impact on a closing basis. Until yesterday, that is.

Monday began like most other days. A quick move at the open was reversed and stock indices proceeded to waffle for a while. Then, as usual, the sell programs began. The fact that the indices were suddenly under attack wasn't terribly surprising because this had become the trend. However, this time, there was no reversal. There were no dip-buyers. And no one appeared interested in "going the other way" once the key technical areas failed to hold.

Lockhart Speaks Up, Again

At first, it appeared that the algos had locked onto comments made by Atlanta Fed President Dennis Lockhart. In a prepared speech, Lockhart, who is a non-voting member of the FOMC in 2013 and 2014, said that he supports the idea of continuing to taper the Fed's QE program over the course of the year. While this did not represent a deviation from Lockhart's well-publicized view on Fed policy, the comments took stock prices down.

Traders may have also been bothered by the fact that Lockhart said one weak unemployment report wasn't enough to deter the Fed from their tapering path. The Atlanta Fed President talked about the improvement being seen in the economy and also made mention of the Fed's "transition away from a QE world."

Frankly, none Lockhart's comments were fresh. As such, it was mildly surprising to see the S&P 500 dive so quickly on what should have been deemed as #NotNews. As such, there appeared to be something else at work.

Goldman Weighs In

While none of the major Wall Street firms has been very good at calling the stock market lately, when Goldman talks, people (oops, I mean computers) listen.

In his latest 'Weekly Kickstart' report, Goldman equity strategist David Kostin declared that the U.S. stock market is overvalued.

Kostin wrote, "The current valuation of the S&P 500 is lofty by almost any measure, both for the aggregate market as well as the median stock: (1) The P/E ratio; (2) the current P/E expansion cycle; (3) EV/Sales; (4) EV/EBITDA; (5) Free Cash Flow yield; (6) Price/Book as well as the ROE and P/B relationship; and compared with the levels of (6) inflation; (7) nominal 10-year Treasury yields; and (8) real interest rates. Furthermore, the cyclically-adjusted P/E ratio suggests the S&P 500 is currently 30% overvalued in terms of (9) Operating EPS and (10) about 45% overvalued using As Reported earnings."

To be sure, Kostin made a bold statement and we will address some of these measures head on in tomorrow's "market math" missive. However, the bottom line is that this appeared to be the "trigger" that the bears have been looking for.

Game On for the Bears?

For quite some time now, it has been tough to be a bear. In 2013, there was just one decline that exceeded 5 percent and you have to go all the way back to May to find the event. Since then it's been a long slog for those seeing the glass as half empty.

However, that may be about to change as the stage may now be set for a pullback that lasts more than a day or two. Investor sentiment is exceptionally high, suggesting that all those wanting to buy stocks may have done so by now. The economy is improving, which would seem to argue for higher rates. Earnings momentum has been slowing. Stocks have become overbought. And as Kostin mentioned, valuations may be starting to be a problem.

So, with a "set up" that appears to favor the bears for the first time in a long time, yesterday's intraday selling could very well "stick." The question now, of course, is if the dip buyers will continue to stand aside or jump right back into the fray.

It is important to note that there was some technical damage done yesterday. However, when algos get going, technical areas become unimportant until after the dust settles. Therefore, the action over the next few days should be interesting/telling.

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