It’s been almost 4 years since the last 10% correction in US stock prices, one of the longest stretches on record. Historically, on average, we get a 10% correction about every 18 months. More severe bear markets, declines of 20% or more, are associated with recessions which are hard to predict and fairly rare. Corrections are most often associated with growth slowdowns that don’t turn into recessions or geopolitical scares, particularly ones that cause a spike in oil prices. Is the long awaited and much anticipated correction – or something worse –  finally at hand?

On the geopolitical front, the world certainly seems a more dangerous place than it has in a long time. The reasons for that I’ll leave to the political experts but it is hard to ignore the turmoil that has engulfed the Middle East. From an investor’s perspective the danger, as it always is with that region, is that the fighting will disrupt the oil markets and cause a spike in prices. As high oil prices are often associated with recessions that is reason enough for investors to be concerned. But so far, even with Saudi Arabia taking a much more active and direct role in the long running battle between Shia and Sunni, oil prices have not been affected. Chalk that one up to the shale industry and the glut of crude it created but oil is a global market and it wouldn’t take much to change the current dynamic. Having said that, I have never placed a heavy weighting on concerns about the Middle East because it has been a mess my entire life and probably will be long after I’m gone. You can’t invest or not based on the latest news out of Iran or Syria or Israel.

In any case, it doesn’t seem the US economy needs a push from higher oil prices to slow down. In fact, just the opposite apparently as the shale bust starts to bite. The economic data has steadily deteriorated since the new year began and last week was no different, although potentially more significant. As it has for months now, the economic news was mixed on the week but Good Friday turned out to be anything but as the employment report disappointed everyone but the most hardened bears. What seems obvious from the flow of data is that the industrial/manufacturing side of the economy is experiencing a major slowdown right now. The regional Fed surveys – almost all of which have been less than expected lately – were again a source of bad news with Dallas, right in the heart of oil country, the latest to show contraction. The Chicago PMI, ISM Manufacturing index and Factory orders all confirmed the slowdown.

There was some good news too. Personal income was up nicely although spending remains punk. Pending home sales showed some life and mortgage applications were higher. Auto sales rebounded to an annualized rate over 17 million. Jobless claims were down, Challenger reported a drop in layoffs and the trade deficit shrunk although not in a way that is particularly positive. Both imports and exports were down on the month with imports falling more at -4.4%, something that is particularly concerning considering the strength of the dollar.

But almost none of that really matters when compared to the employment reports of the week. ADP reported a much less than expected increase of 189k jobs and the official government report was even worse with a mere 126k jobs added versus an expectation of 247k. January and February figures were revised down by 69k. And that my friends was the good news. The household survey showed a gain of just 34k jobs. Involuntary part time workers rose 70k, the labor force fell 96k, the number of people not in the labor force rose 277k and the participation rate fell 0.1 to 62.7%, the lowest since the 1970s. So, to put it mildly, this was not a good report and the recent trend of negative revisions to prior reports is another sign that we may have passed the peak on the employment front.

Weakness on the jobs front is more significant than the other weak reports because the Fed has made employment their main indicator for future monetary policy. That isn’t surprising given that Janet Yellen is a labor economist but it is a bit disconcerting that the Fed is using a lagging indicator as its main tool to gauge future economic activity. The fact is that employment is not correlated in real time with either of the Fed’s dual mandates of inflation or growth. Employment lags growth – we had several months of positive employment reports after the onset of the last recession – and has almost no bearing on inflation; the Phillips curve is widely misunderstood not least at the Fed.

Stocks are not going to like that employment report when the market opens again Monday. The futures market, which was open Friday, immediately sold off after the report while bonds staged another rally. I suppose that could change before the open Monday morning as some will see the report as a positive since it likely means that the Fed’s desire to raise interest rates will remain unfulfilled a while longer. A June rate hike seems highly unlikely unless we get a surge in the economy between now and then, something that looks less likely by the day. And unless this is a one quarter slowdown like last year’s first quarter – which everyone blamed on weather – a September hike is looking iffy as well. And by the way, the seasonal adjustment for this employment report was right in line with historical averages so weather was not an issue.

In addition to the obvious economic slowdown, stock investors also face the likelihood of an earnings slowdown. Earnings season starts soon and estimates have been slashed to contractionary territory. Whether the analysts have lowered estimates sufficiently is the big question and given their eternal optimism, I would be reluctant to bet on earnings being a tailwind this quarter. A lot of the earnings slowdown will be blamed on energy companies and the strong dollar and there is some validity to that but those aren’t the only factors. Sales growth has been weaker than earnings growth for some time now and it isn’t getting better. Stock buybacks have been the difference and one wonders how long corporate America will continue to leverage up to maintain stock prices. If concern about recession rises, the buyback boom will fade and with it support for stock prices. For now though, I’d expect a lot of companies to couple their earnings reports with buyback announcements in the hope that it will be sufficient to keep their stocks from getting hit too hard.

On the technical side, momentum has been waning for months and the indicators I watch are giving long term sell signals. Momentum waxes and wanes quickly in the short term but long term buy or sell signals are pretty rare. The main indicator I use last gave a sell signal in late 2007 just as the last recession was starting. From a price standpoint, support for the S&P 500 looks to be in the high 1900s. If we break that level the next support level – and a weak one at that – is the October low at 1820. Going back to that October low would qualify as a real correction and I think we are likely to see it.

Anything further than that will likely require that the market start pricing in a recession. On that front, despite the current run of weak data, I don’t think we have nearly enough evidence to make that call yet. I use two main market indicators for recession – the shape of the yield curve and credit spreads – and neither is in recession territory right now. The yield curve has flattened but is still far from flat or inverted. Of course, with the Fed suppressing short term rates we don’t know if we’ll actually get to a flat curve this cycle. It seems unlikely that we will get an inverted curve as we usually do before recession but it can’t be ruled out. Credit spreads have widened but it is important, I think, to realize that the widening has come mostly due to a rally in Treasuries rather than a sell off in corporate debt. Widening spreads have an excellent track record for predicting recession but usually because the high yield (junk) bond market is shutting down. We haven’t seen that yet with junk issuance in the first quarter looking pretty healthy. Of course, that is merely a function of a stretch for yield that usually ends in tears so first quarter buyers of junk debt may ultimately regret that decision – but that day of reckoning hasn’t arrived yet.

The current market environment is marked by weakening economic growth, weakening earnings growth and momentum that has stalled. That combination has not been seen for a long time and I think it probably adds up to at least a correction in stock prices. It will be interesting to see what happens if the market gets down 10%. My guess is that down 10% quickly turns into down 15 or 20%. How will investors who haven’t seen a real correction for years react to finding themselves down 10%? My guess is that they will abandon their buy the dip ways. There are a lot of people in this market who don’t really want to be in it – especially advisors trying to mitigate career risk – and they are haunted by the ghost of 2008. Market memories are long and I don’t think it would take much to revive the fear of another market meltdown. The eternal battle between fear and greed has been a draw since November, but fear is the more powerful emotion once it takes hold. The long awaited correction may finally be at hand.

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