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Shrewd ‘Mystery Broker’ Expects a Market Setback

Michael Santoli

In 2013, it’s finally acceptable again to be skeptical about the immediate outlook for the market without invoking Lehman Brothers, the Great Depression, Weimar Germany, or Armageddon.

The fear of an imminent macro meltdown or policy debacle has receded from foreground to background, and so the market debate runs within more-normal bounds of risk versus reward. Investors are back, mostly, to arguing over the direction of the next 5% to 10% for the stock indexes, rather than the next 50%.

With that in mind, the fresh case for a meaningful pullback that would end the recent persistent, sturdy rally rests not on imminent system failure but on a collection of incremental observations on stock valuations, technical conditions, economic velocity and investor-behavior cues.

The veteran financial adviser who has come to be known in some circles as the “mystery broker” for his timely market calls featured here and in Barron’s over the past few years is looking at just such a mixture of signals in calling for a 5% to 10% decline from around the current level of 1,520 on the Standard & Poor’s 500 index.

Good calls

This broker – who chooses not to be identified because he’s not a designated spokesperson for his firm – adeptly predicted a serious bear market in 2007, and then, within months of the market’s March 2009 washout low, turned upbeat, declaring the financial crisis over long before this was widely acknowledged.

Since then he has modulated his market exposures based on tactical evaluations of whether stocks had gone too far in either direction. His current turn toward caution rests on the following factors:

  • The “economic surprise” indexes maintained by Citigroup and other firms, which track how recent economic data compares to forecasts, has rolled over in the past several weeks. He points out that, since mid-2011, there has tended to be a one- to two-month lag between this index turning decisively lower and stocks following along. This pattern usually also involves a rotation from cyclical to defensive sectors, which has only been hinted at in recent market action.
  • There’s a high probability that the automatic government “sequester” spending cuts will kick in and mute U.S. growth further, and if so will come as a surprise to investors now conditioned to expect a benign last-minute deal. He also thinks China’s recovery will be mild, rather than like the vigorous comeback in 2009 (and soft commodity prices seem to support this view).
  • Lower-quality stocks – those with less stability and higher financial risk – have outperformed high quality every month but one since last August, a long streak by historical standards of aggressive segments of the market leading the way. The broker sees this as a sign of frothy risk appetites.
  • The long-tenured Value Line stock research service publishes a measure of the “median appreciation potential” over the next three to five years among the 1,700 stocks it tracks, comparing share prices to a fundamental fair-value estimate. This potential for future returns is now in the lowest 20% of Value Line’s historical observations. This is not a fast-acting market-timing signal but rather an indication that the “average” stock is pretty fully valued – something masked by the cheapness of several mega-cap companies that dominate the S&P 500.
  • As for investor behavior, he sees no sudden or dramatic pivot underway from bonds into stocks, and is skeptical that we are about to see the kind of price-to-earnings valuation expansion that would mark a new long-lasting bull market. The mystery man cites some of the same sentiment cues that others have interpreted as overheated, such as the newsletter advisers followed by Hulbert Financial recommending a near-record long exposure to the Nasdaq.

Blending all this together, the broker figures the pattern of the past couple of years might be repeated. As detailed here this week, in both 2011 and 2012, an early-year rush higher gave way to a choppier period and an opportunity to buy into the market at significantly lower levels toward mid-year.

The most persuasive counterpoint to this cautious view would be that, with central banks having tamed the systemic risks and liquefied the financial system aggressively, and with companies flush with cash and credit markets generous, we are seeing the unleashing of long-suppressed corporate and public risk appetites. This could well drive heavier commercial spending, active corporate acquisition activity, fresh money pumped into stocks and a trend of steadily higher market valuations.

Of course, the two positions are not mutually exclusive: The market can both undergo a sharp and arguably overdue pullback to reset investor expectations and test buyers’ will before reflating to new highs on the strength of plentiful, high-octane capital and refreshed economic enthusiasm.

Which path the market takes won’t likely remain a mystery too much longer.

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