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Sell in May? Absolutely!

The bull market may not be over, but the current stock market rally off of the February correction lows is built on a shaky foundation.

That foundation is the "easy for longer" Federal Reserve, which kept the US dollar down and saved crude oil and other commodities from the deflationary abyss.

If the Fed is the cornerstone of the rally, then the questions become "Why is the market so dependent on very low interest rates?" and "When will they pull the rug?"

I will answer these two questions and then tell you why, under almost all scenarios, the market is in for a rough time this summer even if it does hit new highs.

Why the Market Regrettably Needs an Easy Fed

I have never been one to rant "the stock market is addicted to low rates!" But it's a fact that this condition is now making itself evident. Bear with me while I explain.

Make no mistake, we are in an ugly Earnings Recession. I use capital letters because it should really stand out that we are about to enter the fifth consecutive quarter of negative "growth." While the Oil Bear (I like caps for lots of big catalysts) is largely responsible for the dive, other sectors have been found wanting too.

Even when you strip out Energy, Q1 and Q2 are expected to register -1.8% and -2% earnings "growth" for the S&P 500.

And after several years of record corporate earnings -- partly fueled by record low Fed rate policies and QE bond market subsidies that combined to help finance record stock buybacks -- profit margins have peaked.

So when you have a global Energy and Manufacturing recession that the US clearly cannot hide from, as Q1 GDP of 0.5% attests, it puts the Fed in a difficult position. The FOMC made projections in December that four rate hikes would be appropriate and likely in 2016. That was quickly ratcheted back to just two on worries about "global developments."

MORE . . .


Warning: Bear Market Ahead

The average bull lasts 63 months. We are already 86 months into this one. The question is not IF the bear will strike but WHEN.

Are you prepared? Are you sure about that?

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Equity investors, whether they admit it or not, like the fact that the Fed is cautious and forced to be on hold with rate hikes that would only skyrocket the dollar while Europe and Japan push their rates negative.

But the market also needs low rates right now because it's the only fundamental factor which can justify its current valuations. Trading near 18 times this year's consensus estimate of $115 for the S&P 500, the market is expensive.

In a strong bull market where earnings estimates are rising, you can pay 18X for that upward trajectory of profits. But most institutional investors are finding it hard to come by bargains or earnings momentum that would have them buying enough stocks to sustain new highs in the indexes this year.

How Many Times the Fed WON'T Hike This Year--And Why It Doesn't Matter

Now that I've convinced you the stock market is too infatuated with easy money, let me explain why it's a very shaky marriage even if the Fed takes minimal action this year.

This is important because a lot more can go wrong than go right and large investors may feel they are whistling past the graveyard with a sense of impending dread that something could clobber them out of nowhere. Remember, they need time and liquidity to exit large positions.

Many FOMC members believe the economy is strong enough for higher rates and the Fed needs to be in a faster process of "normalizing" away from crisis levels to get ahead of inflation. Conversely, the more dovish members, led by Fed Chair Janet Yellen, prefer to get ahead of anything else that might be going wrong around the globe by keeping rates, and consequently the US dollar, lower for longer.

This is a good debate among arguably the most important economists in the world. But it is clearly one-sided with only one hawkish dissenter at the April FOMC meeting and it ends up stringing markets along, encouraging speculation in higher-risk investments, M&A, and, of course, corporate buybacks.

The Fed is really in a bind as we near full employment. They know that as soon as they lean toward a clear idea that two or more rate hikes are truly in the cards this year that the US dollar will move strongly higher. This will move the US away from the extremely easy policies of the European Central Bank (ECB) and the Bank of Japan (BOJ).

And this will further dent US manufacturing and oil prices in an already shaky global environment. US equities as the "cleanest dirty shirt" in a world of low yields only works for so long when the market is already over-valued.

So when will they hike? My sense is that even the doves would like to put another quarter-point on the board to look like they have a backbone about this economy. But they probably won't as we head into a summer of "event risks" like the UK Brexit vote and Presidential campaign headlines.

Throw in the possibility for China to devalue the yuan again in one big 2% jump like they did last August, and the doves feel they have a duty to keep a lid on volatility. So that means they won't hike again until September when more is known and much of the uncertainty has been absorbed and processed. But right before the election? Doubtful.

And the market knows all this, with the Fed funds futures markets showing real-money positions worth hundreds of billions of dollars indicating only a 15% chance the Fed hikes in June and only a 35% chance that the target rate will be 75 basis points in September.

"Sell in May" is On Their Minds

Given this shaky foundation for an over-valued, growth-starved stock market, I believe that most institutional portfolio managers will be looking to raise cash on any pushes over S&P 2100 in the next two months.

It's not that a quarter-point increase in interest rates scares them. It's what it means in terms of impacts across the US economy, commodity prices, junk bond yields, the US dollar, earnings estimates, and feedback loops with Europe, Asia, and Emerging Markets. If any summer is ripe for vacations to take precedence and let macro uncertainties just soak in the sun a bit, it's this one.

Will anyone get the timing of a "sell in May" thesis exactly right? Of course not. Just like most of us didn't in buying under S&P 1900 and again under 2000 so that we could cash in profits at 2100 in April.

But the potential reward of 2-3% gains to 2150 is over-shadowed by the potential risks of 5-10% market slides in a matter of weeks. Those are hard to escape from without some big damage to your portfolio, no matter if you are a dividend investor or a growth investor.

Worse, quick 5-10% drops can often unfold into bigger declines if enough negative catalysts line up. I think we are just one more negative Retail Sales or sub-50 ISM Manufacturing report away from a market that stops believing low interest rates can save stocks from low growth.

What to Do Right Now?

I detail specific actions you can take to prepare for the next big downturn in my Special Report, Zacks' Bear Market Game Plan.

It shows how to spot crucial warning signs that the bear is coming and tips you off to 4 bear market blunders you MUST avoid. Our Game Plan also reveals how to target substantial profits from the bear while other investors are paralyzed with fear.

We're providing this Special Report to you free but your deadline to download is midnight Sunday, May 1. I encourage you to read it now.

Download Zacks' Bear Market Game Plan now for free >>

Good Investing,

Kevin Cook

Kevin, a Senior Stock Strategist at Zacks, is a recognized authority in global markets and noted for accurately predicting and tracking market movements. To help Zacks members prepare for the inevitable, he has released his Bear Market Game Plan.


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