Stealth Stocks, Bearish Signs

07/24/2014 9:00 am EST

Focus: STOCKS

Dennis Slothower

Chairman and CIO, Alpine Capital Management

We expect July to be more challenging for the stock market, with corporate earnings announcements and another FOMC tapering event; in addition, the stock market is overbought on an intermediate-term basis, cautions Dennis Slothower, editor of Stealth Stocks.

The central bankers have fought hard to support the financial markets as a mother bear guards her cubs from several threats that gather around them, and this has caused a widening distortion between price and values.

It is a dangerous environment when the US GDP drops 2.9% in 01Q14, down more than previously estimated. Risk is high as more and more people struggle to make it in this difficult economy.

As great as this bull market appears, the backdrop is not so good. The US economy is struggling. If we do not see improvements in the second quarter, as investment bank economists are promising, the second-quarter GDP could also disappoint.

Should we have two back-to-back negative GDP quarters, we have a confirmed recession. Over the next few weeks, the shape the economy is in will set the direction for the markets.

Expectations for a sharp rebound in corporate profits are already priced into the stock market. If the next GDP report disappoints, then the stock market could be headed for a sharp decline.

Who knows where oil prices are heading in this developing Sunni/Shiite civil war, which could cause all kinds of oil supply disruptions in the months ahead?

Studies have shown that crude oil at $115 a barrel or higher has been crushing for the global economy.

Meanwhile, the financial sector has been driving this bull market higher. However, for the second quarter, the financial sector is expected to report the lowest earnings growth of all the sectors—and that is significant.

The financial sector has seen the third-largest decline in expected earnings growth since the beginning of the second quarter. The chart of the SPDR S&P Bank Index ETF (KBE) has shown no progress in the bank sector this year.

Technically, this chart looks to be forming a “heads and shoulders” formation. Should earnings in the second quarter be poor, the banking sector could be rolling over.

We need to watch this very closely because the banking sector has been at the very heart of earnings of the S&P 500 (SPX). If it stumbles and leads lower, the distortion between price and earnings would widen all the more.

We remain in a bull market, but more and more signs are developing that it may not last for much longer.

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