High risk low reward market

As of today we can see S&P 500 climbing new highs in future market and later it may be followed by DJI but since circumstances are changing markets been high risk than rewards. here is why..

The good earnings news was priced in

In our second quarter earnings preview published on July 2, we pointed out that the market had not cheapened up ahead of the reporting period like it often does when estimates come down and companies issue warnings leading up to it.  The Dow and S&P 500 were at, or very near, record-high levels and the Nasdaq was at a 14-year high.

We conjectured that a lot of good news was priced in already knowing the S&P 500 had increased nearly 9.0% since April 11.  That big run, we said, could give way to "...a sell-the-news response in some cases, a more measured gain in others, and a real spoiler of a sell-off for those disappointing with their guidance."

Basically, there just wasn't as much runway as before to take off on better-than-expected results.  

The geopolitical scene has worsened

The downing of the Malaysian passenger jet in eastern Ukraine and Israel's ground assault in Gaza were not on the board when the month began.  They are on the board now.

New economic sanctions have been levied against Russia by the US and the EU alike, raising concerns that they could potentially have a boomerang effect on the global economy in general, and Europe in particular, as Russia digs in to defend its position.

Israel, meanwhile, has stepped up its defense efforts, raising concerns that its battle with Hamas could eventually lead to a wider regional conflict.  To be fair, those concerns have been more talking points than anything else considering oil prices (both Brent and West Texas Intermediate) have dropped approximately 7% since the start of July.

The geopolitical concerns nonetheless have rained a bit on the market's parade because participants are cognizant that a major flare up, and the ramifications for the global economy, could be outside the capabilities of the world's leading central banks to control.

Leaders that should be leading are not

The prevailing narrative entering July was that the US economy is gathering strength and may be poised to sustain a 3.0%+ growth rate on the back of a pickup in both consumer spending and business spending.

Such a development would be good for the small-cap stocks, which are mostly domestically oriented; it would be good for the financial sector, which provides the lubricant for that growth through increased lending; it would benefit the consumer-oriented stocks; and it would bode well for the basic materials and industrial sectors whose fortunes are closely tied to the economic cycle.

That was the hope.  The reality in July was that the Russell 2000 declined 6.1%, the financial sector fell 1.6%, the consumer staples and consumer discretionary sectors dropped 3.4% and 1.4%, respectively, and the basic materials and industrial sectors dipped 2.0% and 4.1%.

Those moves were perplexing because they simply didn't mesh with the prevailing narrative.  At the least, they were regarded as a sign that the market had gotten ahead of itself pricing in the economic recovery.  At worst, they were feared as a disappointing sign of economic things to come.

Sector	July
Basic Materials	-2.0%
Consumer Discretionary	-1.4%
Consumer Staples	-3.4%
Energy	-3.4%
Financials	-1.6%
Health Care	unch
Industrials	-4.1%
Information Technology	1.4%
Telecom Services	2.6%
Utilities	-6.9%
S&P 500	-1.5%

Source: FactSet

The policy dynamic is changing

There are whiffs of monetary policy change in the air and that is taking some shine off the easy-money trade that has dominated for the better part of the last five years.

The Federal Reserve has acknowledged that its asset purchase program is on pace to come to an end in October and it has started to press the reminder that economic conditions could evolve in a way that prompt a hike in the fed funds rate sooner than expected.

Time will ultimately tell what comes to pass on the policy front, but a market that has been accustomed to a zero interest rate policy for such a long time is fighting to get its mind around not only a potential change in that policy, but the timing of when a change will happen.

There are alternate concerns in some circles that the Fed is behind the curve with its zero interest rate policy.  The second quarter GDP report, which showed economic output increasing at an annual rate of 4.0%, and the second quarter employment cost index, which showed labor costs rising at their fastest pace since the third quarter of 2008, helped fan those flames.

  "Other"

What list is complete without the catch-all "other" category?  This list isn't going to capture every point of concern, yet there has been some background noise if you will that has kept the market's enthusiasm in check.

• Worries about the eurozone economy slipping back into recession that have stemmed from the following:
• The push to levy economic sanctions against Russia
• The report that CPI was up just 0.4% year-over-year in July
• The persistent drop in sovereign bond yields to multi-century lows; and
• Capital concerns surrounding Portugal's largest private bank, Banco Espirito Santo
• News highlighting continued outflows from high-yield bond funds
• Technical difficulties
• The Dow, Nasdaq, S&P 500 and S&P Midcap 400 Index have all traded below, and closed below, their 50-day moving averages
• The Russell 2000 has closed below its 50-day moving average as well as its 200-day moving average
• In a highly publicized call, Goldman Sachs downgraded its global equities allocation to Neutral for the short term (i.e. three months), citing its concerns that a sell-off in bonds could lead to a temporary sell-off in stocks
• Increasing media attention on the idea that the stock market is in a bubble and due for a material setback

What It All Means

Everything above sounds very off-putting, but it needs to be acknowledged that the S&P 500 was sitting at an all-time high just a week ago.  Most of the fallout has been recent as all of the factors above it seems have come to a head to force an understanding that the near-term risk reward tradeoff favors the risk side of things more so than it does the reward side of things.

That changing dynamic was at the heart of why we suggested in our Market View update in mid-June to proceed with caution in the near term.

The S&P 500 is trading just below the level it was at when we published that view, which is before it was known that second quarter GDP increased at annual rate of 4.0% and that second quarter earnings per share would be up close to 9.0%.  That's all good, but the price action hasn't been good.

Is this the start of a 10% correction (or worse) that hasn't been seen since August 2011?  We don't know.

We think the stock market's stand-offish behavior in the face of good economic and earnings news speaks to some deep-seated concerns about a potential change in the monetary policy dynamic.  

Layer the geopolitical issues, worries about the market's valuation being full, and a negative seasonal bias on top of that, and there is a basis to think that the easy-money trade won't be so easy for the time being given the perception -- and potentially the reality -- that there is more risk than reward on the horizon.

Source : --Patrick J. O'Hare