The Next 3 Reasons To Exhibit Some Caution

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Tuesday's stock market action was interesting on several fronts. In the morning, it appeared that the bulls were about to recover their lost momentum mojo in response to a second consecutive monthly surge in Consumer Confidence. But then the politicians started making headlines about new sanctions for Russia - and the bottom line is, yes, the algos noticed each and every one of those headlines.

At about 11:00 am eastern time, the major indices had moved to the high of the day and the S&P 500 had retraced all of the prior two day's declines. Things were looking up. After all, when consumers are in a good mood, they tend to spend more time at the malls and/or online - buying stuff. In short, the strong improvement in Consumer Confidence meant the argument could be made that the economy might be able to perform above expectations going forward.

However, about 8 minutes later, the headlines of new sanctions against Russia hit the wires. The sanctions, which were backed by both the U.S. and the EU, included a ban on state-owned banks from selling stock or long-term debt on European markets.

Hmmm... On the surface, this didn't exactly seem like hard hitting stuff. But the algos appeared to disagree. At 11:12, I tweeted the following:

My point, in case it was buried within the sarcasm of the tweet, was that the algos seemed to think this was a big deal. The Dow dropped a quick 130 points in response. And then after a bit of a rebound over the lunch hour, the algos came back in the last 90 minutes to produce another 90 point decline.

No Panic, But Definitely A Reason To Be Cautious

However, the key is that the announcement of sanctions was not news as the move had been well telegraphed. There were no surprises. Everybody knew the EU was going to join the U.S. in imposing sanctions. And yet the algos sold stocks like it was breaking news.

If there was indeed a big, new development that could have a meaningful impact on the global economy or present the risk of war, etc., gold and oil would have spiked, bond yields would have moved down hard, and the CBOE Volatility Index would have surged.

U.S. Oil Fund (USO) Daily

However, oil didn't surge on Tuesday. In fact, oil fell on the session, something it has been doing for the past week.

SPDR Gold Shares (GLD) Daily

The same can be said for gold. There is definitely no panic or even any worry seen on this chart.

No, it appears that stocks were sold by algos reacting to news that really wasn't news. And what this tells us is that the market may be set up for a pullback and that the path of least resistance may be down in the near-term.

This is a long-winded way of saying that another reason to be cautious at the present time is the geopolitical climate. Traders have to keep an eye on Russia/Ukraine and the increasingly violent skirmish in Israel/Gaza at all times. And then on Tuesday, there were developments in Benghazi. As such, some traders may decide to take a time out until things calm down.

Another Reason To Be Cautious: The Algos Are In Charge

As was apparent on Tuesday, the ignition and trend-following algos can be a dynamic duo. These trading bots, as they are called, are really just computer programs designed to either start or follow a trend - on a millisecond basis. And when they get on a roll, the indices can move very far, very fast.

Some folks say the market is rigged. I disagree. However, the algos CAN certainly push the market around - especially during the dog days of summer when nobody is home on Wall Street.

So, if you are looking for another reason to be cautious, the fact that the algos are clearly in charge of the game right now certainly qualifies. And one of the key questions I have on this topic is this: What do you think the algos will do to the market if/when something bad really DOES happen?

The Next Issue: Low Liquidity

Many analysts like to look at the "cash on the sidelines" as a bullish indicator. It is certainly true that if investors - especially the big mutual fund managers - have a big slug of cash sitting around doing nothing, it means there is a great deal of potential buying power for stocks.

This was the case in early 2009 as mutual fund assets relative to the total value of the stock market hit an eye-popping 46%. Clearly, by the time the Financial Crisis Bear Market ended, everyone who had wanted to sell had likely done so and there was a sea of cash available to buy with.

Now fast-forward 5.5 years. The cash to market value ratio is diametrically opposed to where it was in March 2009. Now that ratio stands at just 11.3%. This is the lowest level seen since the tech bubble burst in 2000 and only slightly above where it stood in 1987.

Ned Davis recently summed up this situation nicely by saying that liquidity is like shock absorbers on an automobile. With good shocks (i.e. plenty of cash on the sidelines), the car/market can easily absorb the bumps in the road (because the dip-buyers have plenty of money to play with). However, when those shocks become worn thin, well, the bumps might make the ride tougher to handle.

Coming Up... Some of the other reasons that it might pay to be cautious include: The reading of our Market Environment Model, the levels of speculation, sentiment readings, public and private exposure levels, valuations, the return of the politicians, Europe's economy, streaks, and the VIX...

Turning To This Morning

Although the geopolitical issues around the world have not gone away, traders appear to be focused primarily on the state of the U.S. economy, earnings and today's FOMC meeting. This morning before the opening bell, investors will get the first revision to the second quarter's GDP growth rate. And then this afternoon, the Fed will provide its latest outlook on the economy and what changes, if any, are currently needed with regard to future monetary policy. Overseas markets are fractionally mixed while U.S. futures are pointing to a stronger open on Wall Street.

Pre-Game Indicators

Here are the Pre-Market indicators we review each morning before the opening bell...

Major Foreign Markets:
    - Japan: +0.18%
    - Hong Kong: +0.37%
    - Shanghai: -0.10%
    - London: -0.08%
    - Germany: +0.08%
    - France: -0.10%
    - Italy: +0.08%
    - Spain: +0.74%

Crude Oil Futures: +$0.33 to $101.30

Gold: +$0.60 at $1298.90

Dollar: lower agains the yen, higher vs. euro and pound.

10-Year Bond Yield: Currently trading at 2.475%

Stock Futures Ahead of Open in U.S. (relative to fair value):
- S&P 500: +5.50
- Dow Jones Industrial Average: +46
- NASDAQ Composite: +17.72

Thought For The Day:

Life is not complex. We are complex. Life is simple, and the simple thing is the right thing. --Oscar Wilde

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Positions in securities mentioned: None

Wishing you green screens and all the best for a great day,

David D. Moenning
President, Chief Investment Officer
Heritage Capital Research
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