Market Correction Ahead?

While the captain and the officers on the bridge argue about how to steer the ship, a crewman taps them on their shoulders and warns, “Hey, guys. You might want to look out the window. We’re running aground.”

Friday’s new jobs number hit the U.S. economy like a huge submerged rock that no one expected. Only 88,000 new jobs were created in March in the entire country, less than half of the 190,000 predicted.

Of that amount, 18,000 new jobs went to construction, indicating that the housing recovery is still strong, even though the number was lower than last month’s. Another improved number was the unemployment rate, which fell to 7.6% from last month’s 7.7%.

But looking more deeply below the surface of the numbers, we can see some pretty large rocks scraping along the economy’s hull. Some are saying the only reason the unemployment rate fell by 0.1% was because 500,000 jobless people simply gave up looking for work in March.

Overall, the labor-force participation rate fell 0.2% in March to 63.3%, meaning fewer people are working or actively looking for work.

Is the Recovery Stalling?

All totalled, Friday’s reports killed the optimism from just one month prior. January’s and February’s jobs reports got the year off on solid footing, setting the tone for a bullish March. In fact, the first two months’ jobs numbers were even better than previously reported, and they were revised up by 61,000 jobs.

Stock markets continued to climb through March as both consumer and investor sentiment strengthened. Optimism abounded that yes indeed the U.S. economic recovery was solid and sure.

Some are not so sure anymore. Explains the Wall Street Journal:

“The jobs numbers reflect ‘a very sharp slowdown,’ said Paul Ashworth, chief U.S. economist at Capital Economics in Toronto… the weak growth may be a more accurate reflection of the fragile recovery.”

Many are blaming the government sequester—that general sweep of spending cuts straight across the board without much scrutiny over which cuts are beneficial and which are detrimental—which came into effect in March.

“I chalk some of it up to trepidation over the sequester,” blamed Eric Lascelles, chief economist for RBC Global Asset Management in Toronto, as quoted by the Wall Street Journal. And the damage may have only just begun, as the paper adds, “Economists said the sequester’s effect is likely to ripple through the recovery in the second and third quarters.”

Furthermore, “The nonpartisan Congressional Budget Office has estimated that the sequester will cost the economy 750,000 jobs,” cites the Washington Post.

“While the recovery was gaining traction before sequestration took effect, these arbitrary and unnecessary cuts to government services will be a head wind in the months to come,” said Alan B. Krueger, head of President Obama’s Council of Economic Advisers, as quoted by the Washington Post.

These sequestered cuts came about because the big wigs in Washington can’t stop arguing long enough to sit down together and sensibly work out a budget. While they continued to argue, the sequester autopilot took over, with the potential to steer the economy into the rocks.

What will happen to the stock market now? Will last month’s optimism give way to worry? Will the bull yield to the bear? The charts may have something to say about that.

Will Markets Correct?

Even before Friday’s weak jobs numbers came out, the smart money had already been shifting out of growth stocks into the defensives. “Lately defensive stocks have been leading the charge, and notable growth indexes are slipping,” Reuters noted over the weekend. “This rotation has many thinking the long-awaited market correction is nigh.”

Two things were already prompting the flight to safer stocks: higher payroll taxes for 2013 and the $85 billion in sequestered government cuts. To that, we now add the third puncture in the hull delivered by Friday’s employment reports.

Yet there is a whole reef of submerged corrals and rocks fastly approaching that could finally run the ship aground: earnings reports beginning this week. They are not expected to be good.

The negative-to-positive guidance ratio from S&P 500 companies is at 4.7—which means 4.7 companies are expected to report below consensus for every 1 company reporting above consensus. It is the highest the ratio has been since Q3 of 2001.

The combined impact of all these blows could be what sends the markets cascading down the right slope of a head-and-shoulders pattern that has been forming for weeks.

Source: BigCharts.com

The blue and red lines may have begun forming the left half of a head-and-shoulders pattern (blue left shoulder, red head), a signal that the market is cresting and about to correct.

The Dow Jones Industrial Average shown above has already been struggling to break above the 14,600 area for some 2 to 3 weeks now. Weak earnings reports on top of last Friday’s dismal jobs numbers could finally send the market down to the shoulder level again, or 14,000, for a decline of 600 points, or 4%.

At that level, the right shoulder would form over the course of a week or two. If the correction were to continue from there for yet another leg down, the Dow could fall to the previous ceiling of 13,600 (left of green—the ceiling becomes the floor) for a drop of nearly 7%.

Or it could fall even further to the very start of the rally at the 12,500 area of major support (purple line) for a total correction of 2,100 points, or 14%. As some believe, 2,000 points upward in 5 months is a long way to go without a healthy pull-back.

However, the bulls are not worried one bit. They believe the Fed will continue to provide the market with the ballast it needs to remain buoyant.

To them, the recent top (red line) is no top at all, but just another step up like the previous two steps (blue and green), with more upward movement to come.

Whether the market is overheating or not, the MACD shown at the bottom of the graph is telling us this much: at readings over 150 during the past two months, the market is more overbought now than it was in December (green), and much more overbought than it was in October when it corrected some 1,000 points, or 8% (yellow arrow).

Investing in an Uncertain Market

So what is an investor to do? How do we trade this market? The first thing to do is not get overly excited.

Remember, Federal Reserve chairman Ben Bernanke has repeatedly stated that the Fed will continue to support the economic recovery with its monthly bonds and mortgage purchases as long as the unemployment rate remains above 6.5%, which it does at 7.6%. And the dismal jobs reports from Friday strengthens that case all the more.

So let’s not throw out the baby with the bath water. Perhaps following the lead of the smart money might lend some guidance on how to manage this market, with positions moving toward defensive, large-cap stocks that have solid cashflow and low debt. These are companies that won’t be so quickly tossed upon the shore if the wind were to suddenly change direction for a while.

If only the officers on the bridge of this economic freighter would just set aside their partisan agendas for a moment. Just take a little breather from their elephants-vs-donkeys politicking and sit down together long enough to work out a sensible budget to steer the economy away from these rocks.

When you’re done with that, maybe you’ll have a better appreciation for how to better serve your country when it needs you most.

Joseph Cafariello

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