I have been bullish for the past couple of months but a few hints have started to add up and sway me towards a more cautious stance on the SPX.  The risk-reward has decayed materially over the last couple of weeks.

There looks to be more enthusiasm for the equity markets then we have seen for some time.  While the “dry powder thesis” of real money stashed in fixed income remains intact, the reduction in perceived tail risk has conjured up a fairly bullish consensus.  My sense is that there is less reluctance to buy equities, which I find to be highly interesting since the forced nature (i.e. the divergence between intention and action) of the move off the 2009 lows has been its defining characteristic.

Meanwhile, retail money has been sufficiently enticed to join the action after missing the entire move.  Investors continue to be cheered by the pricing out of tail risk in Europe and green shoots in China.

The internals of the rally have been positive thus far, with industrial/materials outperformance and a breakout in the Dow Transports.  Taken differently, however, the chart above looks like a double top.

As pointed out by Mark Dow on his excellent blog Behavioral Macro, the Citi Economic Surprise Index has been plummeting, reflecting a weakening of economic data versus expectations.

We also have a 150bps hit to GDP coming from the fiscal cliff tax deal, which represents 120bps of disposable income.  Consumer confidence soared through H2’12 on slowly recovering employment and the housing market rebound, but this sudden reduction may have a larger impact than the market is anticipating.  Anecdotally, most people seem to think that taxes were only raised on the wealthy, and may be surprised when their first paychecks show up somewhat lighter than before.  With the combined debt ceiling / sequester / continuing resolution showdown coming up as early as late February, fiscal policy looks to be a significant drag on GDP in 2013, particularly in Q1.  Another concerning factor is that the market seems very complacent about the upcoming battle given the minimal equity market reaction to the tax cliff debate.

Looking at the chart of the SPX off the 2009 lows, I find it highly interesting that each leg of the rally is progressively weaker and shorter.  There have been many iterations of this chart transposed against the timeline of Federal Reserve actions, seemingly highlighting the diminishing returns from each incremental easing.

A quick analysis shows that the rallies have been getting progressively weaker and shorter in duration, with the cumulative volume of each leg approximating ~50% of the previous leg.  What does this say about the current move higher since mid-November?