Prepare for a Correction?

We are not trying to overload you with commentary early in the New Year, but we think it is critical that we share with you our perspective on how we see the economy and what you might expect to happen in the stock market over the next few months. We recommend you prepare yourself for a correction even though it may not happen.

Here's part of why we think it could happen. Historically, earnings season was kicked off by Alcoa reporting, but that is no longer the case. The new Alcoa does not report until January 24th while three large financial institutions will report this Friday morning. So we count Friday as the beginning of earnings season. Investor optimism has been pretty strong as we enter this season, so there's plenty of room for disappointment. Over the past month, however, optimism has been on the decline for both Smart Money as well as Dumb Money, and during that time we've seen markets stall.


We are not suggesting an end to this bull market, not by any stretch!  Today the NFIB Small Business Optimism Index jumped to its best reading since December 2004.

This is a non-partisan way of looking at the confidence level of America's jobs-producing engine. When small business grows, the U.S. economy grows. Could this be evidence we will sustain GDP growth levels above 3%?

It could. And that could bring with it a more aggressive Federal Reserve that raises interest rates much faster than is now expected. We believe this bull market will eventually be killed by an overly aggressive Fed that tightens monetary policy too much. When it comes to the Fed…history will repeat itself. It always does.

With that said, we do not expect a “too-tight” Fed in the immediate future, perhaps not even this year. But it behooves us to keep a close watch on inflation which, if it ratchets up, will cause the Fed to raise rates higher and drain the economy of monetary fuels needed to sustain higher growth. The NFIB Survey tells us that small business owners as of December 13, 2016 have plans to hire more workers, build inventories and expand their businesses by borrowing. This should result in enhanced capital expenditures and stronger growth which can be a powerful engine for the stock market, but it can also lead to rising inflation and a grumpy Fed.

When we have entered earnings season with this 

much optimism among investors and small business owners, stocks have usually been weak over the following month. This time could be different, and there are reasons to expect a difference, especially if earnings do not disappoint. We will get some idea this Friday from financials.

Small business is not the same thing as small capitalization stocks as represented in the S&P 600 Index or the Russell 2000 Index. However, among publicly traded stocks these two indices are "small cap." We've been over-weighed in small and mid-cap equities and expect a year of out-performance from these capitalizations. Currently, both have stalled over the past month and have been weaker than their large cap cousins. Take a look in the next chart where I compare the Russell 2000 with the S&P 500.

The Russell 2000 made an all-time high in December. Since then it has gone no more than 2.5% in either direction. More stocks in the index have gone down than have gone higher. This is known as a consolidation pattern and most of the time what follows is further weakness with declining prices. So far this year we've seen a surge in the large cap technology stocks [QQQ] which is made clear from the next chart where I compare the S&P 500, the Russell 2000 and the NASDAQ-100:

I want you to notice two things in the graph to the left: 1) the outperformance from the NASDAQ-100 [blue line] and 2) the higher volatility in the Russell 2000 [gold line].

Looks good for the NASDAQ-100 or QQQ, doesn't it? We pointed out earlier this week that market breadth was heavier to the downside for the New York Stock Exchange (NYSE); that is, more stocks were going down in price than were going up in price even on days when the S&P 500 and other indices were going higher. This is also true for the NASDAQ and for the NASDAQ-100. This divergence should give you a different perspective on that blue line. It does not represent most of the stocks in the NASDAQ-100, only those with the most weight that have gone up.

Now, I want to write a bit about the gold line, the Russell 2000. This year we expect most of our individual securities that we hold to be in the Russell 2000. Individual securities are much more volatile than any index. That means that when (if) we have a downward adjustment in prices this year a portfolio made up of individual securities will likely go down much more than indices as a whole. That is because indices are made up of hundreds of individual securities and are, consequently, less volatile. Our portfolios are currently made up mostly of Exchange Traded Funds (ETFs) that are linked to various indices: capitalization weighed or sectors or industries. We may not reduce those positions and go to individual securities until we get the price adjustment or correction we anticipate, thus giving us a better opportunity to buy these individual securities. In other words, we are managing risk exposure through the use of less volatile ETFs.

We have not changed our view on the 2017 economy or the stock market. We remain positive f

or both.