The death toll mounts. The number of cases worldwide builds. Every new update drives the stock market up or down. Where it will end is anyone's guess.

 

It is called a "geopolitical" event. We suffer through them from time to time. The assassination of Iran's key military leader followed by the Iranian rocket attack on two Iraqi military base that injured dozens of American servicemen was the last such event. We never know when they will occur and, in some ways, these events are simply the price of doing business in the financial markets.

 

Some market watchers, while recognizing the severity of the coronavirus outbreak, argue that the markets needed to correct anyway. This outbreak was simply the excuse investors needed to pull the trigger and take profits. I believe there is some truth to that opinion.

 

However, we should recognize that the coronavirus will most likely put a dent in economic growth around the world. Certainly, in the case of China and other nations closer to the epicenter of the outbreak, we can expect a slowdown in economic growth. After all, you simply can't shut down 16-plus major cities during the Chinese New Year, the largest consumer spending day in that country, without consequences to business.

 

In the U.S., a host of companies should also feel the heat as they too suspend business in their Chinese operations. This quarter's earnings season revealed that 25 percent of company managers expect some impact to their bottom line as a result of this calamity.

 

There have been some reports in the media (and accusations by others) that the number of cases reported by the Chinese government are being deliberately low-balled in order to soften the blow on business and to reduce the chance of whole-sale panic. So far, the World Health Organization, while sounding a global health emergency, is more concerned about the spread of the virus in countries with weaker health systems than what is happening in China, where more than 10,000 cases have been reported.

 

While no one can know for sure how long, or what ultimate impact this disaster will have on economies and markets, I believe that like all geopolitical events, they have limited impact and are of short duration.  I can see a 5 percent decline in the S&P 500 Index as a predictable outcome, but not much more than that. We are already off 3 percent from historical highs, so I am not talking about much, maybe a decline to 3,200 or a little below that on the index.

 

This week's Federal Open Market Committee's decision to hold interest rates steady turned out to be a snooze fest for investors. In the Q&A session after the announcement, Chairman Jerome Powell did mention that the Fed planned to begin tapering their purchases of short-term U.S. Treasury bills by the second quarter of this year. He reiterated that the purchases they have made since last September were "not QE" and the Fed could not be held responsible if the financial markets thought differently. Maybe investors are finally beginning to believe that, which may also have contributed to the present sell-off.

 

As of Friday's close, I suspect that we will have given back most (if not all) of the gains we have enjoyed since the beginning of the year. That should have been expected, since historically, we usually have a late January-into-February pullback in the markets. My advice is to look beyond this event and focus instead on regaining the record highs sometime before the end of the first quarter.

 

The stock market is frothy. The great gains that investors experienced last year are extending into this year. As the indexes climb, more and more of those on the sidelines are jumping in. Is this a good sign?

 

No, it isn't. "The Fear of Missing Out," or FOMO is rearing its greedy head on Wall Street. Those who may have raised some cash in the past few months, fearing a trade war, or the impeachment proceedings, have watched the portfolios underperform the averages, ignore all the negative news and climb higher.

 

On the geopolitical front, we have seen the same thing. Selling on fear of an Iranian response to the killing of one of their heroes was the wrong move and, evidently, so was taking profits on this week's fears that the China-based coronavirus would spread, denting world economic growth.

 

Anecdotally, I have been getting requests from some of my tell-tale clients (those who want to buy at the top and sell at the bottom) to buy stocks at historic highs, where their prices exceed all rational measures of valuations. They are usually a good contrary indicator.

 

As is the U.S. Advisors Sentiment Indicator. This week's numbers underscore the gathering bullishness of market participants Those professionals who are positive on the market's future moved even higher to 59.4 percent. That is the highest it has been since September 2018.  And as the present rally broadens, we can expect that next week the bulls should top 60 percent.

 

In the past, a 60 percent bullish read would have had most who follow this indicator running for the hills, in the short-term. But so far, the opposite has occurred. Granted, investor sentiment, as a contrary indicator, is not the only variable used in trying to discern the stock market's next move. I believe that the actions by the Federal Reserve Bank will almost always trump sentiment as a determining factor. So, let's look at the Fed.

 

As I have predicted throughout the last several months, as long as the Fed keeps pumping money into the financial markets, I believed stocks would continue to rise. Since the beginning of December, the combined reserve management purchases, plus repo injections by the central bank, has been about $400 billion. The Fed argues that since they have only been purchasing notes (and not bonds with a coupon), their purchases do not qualify as quantitative easing (QE). The market doesn't care. To them QE is QE.

 

These "Not QE" purchases, however, have been so huge that the central bank is approaching the limit of purchases it can make of these short-dated securities without disrupting the market. At the present rate, there will be no notes left to buy in a month or two. As a result, traders are now betting (75 percent probability) that by mid-March, the Fed will have to expand their purchases to include longer-dated Treasury bonds.

 

The logical question to ask is why doesn't the Fed simply stop these purchases? It could be because the Fed has created its own version of "Frankenstein's Monster."  As I have written before, the Fed has dumped such an enormous amount of money into this market that by stepping back from more purchases (no matter how small), the Fed could disrupt the whole market.

 

The bet is that rather than risk that, the Fed might simply begin to expand its bond purchases to include longer-dated debt maturities with coupons. Of course, once that happens, the Fed would have to admit that, yes, they have embarked on yet another QE program. You might ask, "so what's wrong with that?"

 

The first question investors might ask is why? The stock market is assuming that everything is right with their world. Jerome Powell, the Fed's chairman, has said so over and over again. The president has said so even more times than the Fed. So why do we need another QE program after cutting interest rates three times last year? What's wrong? The Fed's actions, far more than anything else, have driven the stock market to its present record highs. Investors will demand an explanation — and soon.

 

The second, darker explanation may be that the Fed is no longer the independent body it claims to be. After all, Powell was appointed by the president. The president has voiced his unhappiness with his man's actions since he got the job. Trump is a staunch believer in easy monetary policy and wants the economy to grow as fast as it can to cement his election chances.

 

What better way to do that than by getting the Fed to pump money into the system via "Not QE," since few of us understand something as arcane as the "repo market." Whereas, cutting interest rates to zero at the president's request would be an extremely optic moment for all involved. Whatever the answer, the Fed's future actions should be watched closely.

 

When asked, the members of the Federal Reserve Board continue to argue that the almost $500 million they have pumped into the overnight repurchase market since September is not quantitative easing. The stock market disagrees.

 

"Not QE" is the term most often used by the Street in describing this fairly hefty expansion of the central bank's balance sheet. Because the purchases that the Fed is making are categorized as debt instruments that mature in 12 months or less, they escape the hard and fast definition of what the Fed labels as quantitative easing. QE is the purchase of longer-dated maturities of debt instruments, so the Fed is technically correct.

 

However, traders are folks who like things simple. Over the past decade or so, when the Fed expanded its balance sheet (bought bonds) the stock market climbed. As far as the Street is concerned, it has happened again starting in September, and so far, there is no end in sight.

 

There are various explanations (none proven) for exactly why the Fed is making these purchases. Officially, the Fed argues the entire exercise is simply technical in nature. The Fed explained that for various reasons — quarterly tax payments, bonuses, etc. — corporations need more cash to make ends meet, but this trend will soon fade. The problem is they have been saying that for over four months.

 

Others worry that some big bank is in trouble, or that this is a new strategy by the central bank to ensure a soft landing in the economy by graduating over time from purchasing short dated debt to full-fledged QE purchases of longer majorities somewhere down the road.

 

I ask myself what could the Fed be worrying about that the market doesn't see quite yet? It is fairly obvious to most economists that the manufacturing sector in this country is in recession. We are also in our third quarter of falling industrial production. The good news is that the manufacturing sector represents less than 8.5 percent of overall jobs and less than 10 percent of the economy. So far, none of the woes in that area has spread to the overall economy.

 

There is a chance that if the downturn in manufacturing persists, it might at some point start to impact consumer spending, which is the locomotive that drives the U.S. economy. However, there is no evidence of that as of yet. In the meantime, the stock market continues to make record highs. And as long as the Fed keeps the spigot in the "on" position, the stock market's cup should continue to runneth over.

 

The signing of the Phase One China trade deal also cheered investors this week. The vast majority of Wall Streeters have not been fooled by the hours-long signing and celebration of the event by the administration. The deal, if one can call it that, is a win for China and not the United States. The fact that the really difficult issues remain and will not be resolved until after the election (if ever) reduces the upside from this event.

 

About the best that can be said for the deal is that it does reduce tensions somewhat going forward. It also gives the president a chance to claim another success (no matter how lame) among his followers.

 

It was another up week for the stock market. As we hit record high after record high, investors want more and expect to get it. Forecasts are getting even rosier for this year and, if all goes well, we can expect the signing of the long-awaited Phase One China trade deal next week. What's not to like?

 

Geopolitics for one thing. As I wrote last week, investors should expect a response after the killing of Iran's No. 2 guy, Gen. Qasem Soleimani. I expressed hope that it would be sooner rather than later since the market hates the unknown. That turned out to be the case.

 

The Iranian response, however, was largely symbolic. Several rockets that did little damage and took no lives landed on two military bases in Iraq. Both sides then seemed to dial down the rhetoric and go back to their respective corners — until next time.

 

While the week saw some wild swings in the averages by Friday, it was on to the next thing. That turned out to be the non-farm payrolls report for December. Economists were expecting 160,000 job gains but received only 145,000 instead. Although that still keeps the unemployment rate at a 50-year low of 3.5 percent, wage growth also disappointed. Average hourly earnings grew by 2.9 percent. That is the first time since 2018 that wage gains were below 3 percent on a year-over-year basis.

 

But nothing negative seems to stick to this market. Rockets, impeachment, weak manufacturing data, even the weak job numbers have, at most, provided small dips in stocks at best.  As I mentioned last week, the investor sentiment numbers have been flashing red signals. More and more market strategists are warning of an "imminent" decline of 5-10 percent, but few care.

 

Don't think I am complaining. I enjoy a bull market as much as the next guy. However, the underlying reasons for this uninterrupted march to the clouds may be somewhat troubling to ignorant folk like me. I don't believe the tweets that take credit for all-time highs that are coming out of the White House. Nor would I believe that exercising military muscle against a tiny Middle Eastern country is all that bullish, except in the eyes of the "chosen few." It is still all about the Fed, in my opinion.

 

In several columns last year, I wrote about the sizable sums of money that are being injected into the nation's repo market by the U.S. central bank. It started last year and was supposed to be a temporary measure. The argument was that corporations were facing a cash crunch and needed extra funds to pay quarter-end tax bills. The quarter had come and gone and yet, by Christmas, the Fed had pumped almost $1 trillion into that market.

 

Dumping all this money into the market was like launching a stealth quantitative easing program (QE) that is almost as powerful as cutting interest rates one or two more times. I also predicted in December that the stock market would move higher as a result of an additional $255.95 billion that the Fed planned to dump into repos at year-end. However, that was supposed to be the end of this quiet QE exercise. 

 

Guess what? The Fed injected even more money ($258.9 billion) into repos last Friday. No one actually knows why or what is going on at this stage. All the excuses the central bank has used to explain the market's need for so much cash now sound shallow and certainly less than kosher.

 

I believe the end result has been that this money is being siphoned out of the repo market by enterprising financial institutions. It is then finding its way into the stock market where the arbitrage opportunities of borrowing at next to nothing and investing it in much higher rate of return stocks is going on at a furious rate.

 

The astute reader might ask, "what happens if and when the Fed stops injecting this money into the repo markets?"

 

Well, if I am right, we should get that 5-10 percent pullback everyone is expecting. The question is when does the Fed take away the punch ball?

 

Donald Trump's decision this week to kill Iran's second-most important figure, Gen. Qassem Soleimanai, this week placed a time-out on the stock market's bull run into the New Year. Do you run for the hills or do you buy the dip?

 

If I look back to other geopolitical events, my first reaction is to use any further declines as an opportunity to increase exposure to the stock markets. At the same time, I wouldn't chase those categories of assets that have vaulted higher in response to this event. Gold and oil both moved higher overnight, but those gains could be fleeting as investors begin to assess whether or not there will be any further downside.

 

That is not to say that dropping a bomb on the architect of many of America's greatest problems in the Middle East will go unanswered by the Iranian government. How and when the Iranians respond should keep all the markets on edge in the near future. And therein lies the problem.

 

In my opinion, the best of all possible outcomes is for the Iranians to respond quickly, maybe this weekend or next week. That would give our side the greatest chance of thwarting such a move because we would be on high alert. As time passes, however, human behavior is such that gradually we would begin to let down our guard.

 

In the same way, investors will be cautious at first, but as time goes by without a response, it will be back to business as usual. Until it isn't. And while geopolitical events are always a risk when investing, the high valuations that presently exist throughout the markets could set us up for s a significant fall. Of course, it depends on what and how successful the Iranian response is.

 

Clearly, from a number of indicators such as momentum, sentiment and in some cases, extreme valuations, stocks are due for a pullback. This week's US Advisor Sentiment report indicates extreme overbought conditions right now. The bull/bear spread expanded to 41.1 percent from 40.4 percent. In the past, differences above 30 percent signal concerns and those over 40 percent indicate investors should begin to take defensive action.

 

For many of us, the spectacular gains we have enjoyed in 2019 set us up for disappointment this year. Like everyone, I would love to see this bull market continue. I am as greedy as the next guy, but I have been in this game long enough to know that rarely happens. And while the majority of strategists and analysts are uber-bullish right now about the prospects for stocks this year, that could change at the first hint of adversity.

 

As such, don't get your hopes up too high right now. What you wish for the most (more upside), would simply set us up for a nasty decline when we least expect it. Prepare, instead, for some volatility. Expect stocks to decline, likely sooner than later, possibly even before this month is out. And if it were to occur, whether because of Iran, a snag in the Phase One trade deal, or something else, be glad, be happy, because it could set us up for further gains in the months ahead.