Bracing for a Selloff    

• The US and most overseas equity markets have reached the point where upside surprises in the economic data are needed to keep the rally going. Thus last week’s disappointing data on US employment and factory orders had investors bracing for a selloff. On the other hand, the last thing that investors want to hear are suggestions that central bankers and governments are confident enough in the recovery to begin removing the extraordinary stimulus that is fueling the rally to date, and this is the current quandary.
• While our working assumption remains that an interim correction at this point would set the stage for a "Hallowen" effect through early 2010, two possible longer-term scenarios linger in investor minds.
• The more benign scenario is, a) there is a short-term correction of 10%~15%, and b) the market thereafter trades sideways for a time, like the post IT bubble market in 2004. The darker scenario (as outlined by Elliot Wave chartist Robert Prechter) is that the S&P 500 is closely tracking the Heisei Malaise secular bear market in Japan. If this correlation continues, the market could have one more uptick before eventually falling through March 2009 lows as the secular bear market resumes.
• Fundamentally, the latter scenario is predicated on the observation that massive fiscal and monetary stimulus in Japan failed to generate enough sustainable economic growth to allow Japan to "grow" out of its quagmire and left little but a negative legacy of massive government debt that is now choking off GDP growth.  As a result, Japan's stock market has renewed the 2003 low and from a long-term perspective is still in a secular bear market.
• Whle the Fed and US treasury will vociferously deny this possibility, the recovery so far has failed to convince most investors, let alone uber bears, that this darker scenario has no credibility.
• Over the past month, Japan has severely lagged global stock markets because pronouncements by the new DPJ-led government are spooking both investors and Japanese management, while a surging yen threatens to exacerbate an already bad situation in Japan’s economy.

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