A Rebound Attempt

Here is a brief update on the action in the stock and bond markets. In Wednesday’s trading, the stock market initially declined sharply and the action was accompanied by a frenzy of short-covering in treasury notes across the maturity curve (see Tuesday’s comment on the outsized speculative net short position in 10 year notes. Similarly large speculative short positions are also extant in shorter maturities).

The “trigger events” were many – an overnight plunge in crude oil prices cemented the idea that a global economic slowdown is underway (which seems indeed to be the case) and this idea received further ammunition when a few US economic data were released. Producer prices fell and the Empire State manufacturing survey plunged by 21 points, way below expectations. Significantly, new orders declined sharply (for more details on the survey see Mish’s write-up).

Of course, we don’t believe that the stock market is weakening because punters have suddenly found out that there is economic weakness. As so often, the fundamental news follow the market and don’t lead it – what’s more, the very same news would likely have been ignored only a few weeks earlier, or even have been met with bullish spin. The real reason for stock market’s weakness is the declining growth momentum of the money supply and the impending end of “QE3”. This has already created a great many negative effects in “risk assets”, which were merely masked by the previous strength in popular cap-weighted indexes. Readers may also want to check the comments by Variant Perceptions on the recent decline in stock buybacks and the market’s reliance on multiple expansion. Both seem relevant data points, which we have previously discussed here as well.

Wednesdays before option expiration have in the past very often marked turning points for the week. If memory serves, there actually exists some statistical proof for this. It also makes sense insofar as the market has a tendency to close on expiration day at levels that ensure that the majority of options will expire worthlessly (“maximum pain”). Thus, if the market has trended in one direction for a while, it will briefly move in the other direction. Obviously, the daily charts of the indexes all sport candles that suggest a short term reversal could be in the offing as well. Moreover, trading volume has finally spiked on Wednesday.

However, there are a few major caveats, which apply regardless of whether such a bounce happens or not: the increasing intra-day and daily volatility is not a sign of a healthy market. Rather, the recent action should be regarded as a major warning shot. Moreover, market psychology is still not indicative of a lasting low, as there simply is not enough fear yet. This suggests that the moment when fear is palpable is yet to come. We would be very careful about embracing a bounce, if indeed a bounce is in the works. Given that momentum darling NFLX cratered by 25% in after hours trading after an earnings miss and WMT warned of slowing sales, the market’s mood may continue to be sour. Below is the chart of four important indexes we already showed on Tuesday with updated annotations:

The previous downside leader Russell 2000 led Wednesday’s reversal from the abyss. We already pointed out the change in its relative performance on Tuesday (it actually became first noticeable in Monday’s trading) – click to enlarge.

Market Psychology Still Too Complacent

While the spike in trading volume has “mini capitulation” qualities, it is still far from the kind of trading activity we would expect to see at a genuine panic low. Moreover, equity put-call ratios show that option traders have been very quick in embracing the rebound. In other words, their main concern seems to have been to bet on the rebound continuing, instead of using it to increase their exposure to further downside. This shows that market psychology is probably not fearful enough just yet:

Equity put-call ratios indicate that option traders very quickly switched from buying puts to buying calls on Wednesday – click to enlarge.

The idea is also buttressed by anecdotal evidence. Browsing through financial media sites, we have come across many articles downplaying the importance of the action, simply blaming it on “technicals” and so forth.

Well known perma-bull Laszlo Birinyi (who is right approximately 67% of the time, because this is the percentage of time during which the stock market rises on average over the past century) at least amused us by noting that he’s apparently “not sure what is going on with stocks” (it is amazing how much confusion a correction of a few percent seems able to create).

As an aside, Deutsche Bank’s most recent short term market forecast turned out to be very wrong – we mainly mention this because it once again shows that short term forecasts are generally not much better than coin flips. However, we are still surprised that the analyst so blithely ignored the obvious deterioration of market internals, which should at the very least have been cause for adding a caveat to the forecast.

On the other hand, extrapolating what has happened up until the beginning of October indefinitely into the future has worked for a full two years, so in that sense it is perhaps understandable why no such caveat was mentioned. It sure seems as though this kind of extrapolation will no longer work.

We were also astonished to learn that Janet Yellen is about to be wheeled out to declare her “confidence” about the economic recovery. This is what the Germans call “gesundbeten” (literally “praying for health”, but it basically means “to declare something healthy in the face of glaring evidence to the contrary”). Others were meanwhile busy slashing their GDP forecasts (once again). The Fed’s economic forecasting record is so dismal, the less said about it, the better – of course that is not how they see it themselves.

Bond Market – A Short Covering Panic

10 year treasury note yields briefly plunged below the 2% level on Wednesday. At first we thought we weren’t seeing right. Apparently though the big speculative shorts in treasuries caused a short covering panic after the release of the producer price index and in light of the continuing weakness in stocks. This may well have put in a short term peak in treasuries:

TLT (long term treasuries ETF) and HYG (junk bond ETF) – moving in opposite directions – click to enlarge.

Conclusion:

The markets remain “interesting”. As we are writing these lines, crude oil and stocks in Europe are once again weakening, so yesterday’s late-day rebound on Wall Street has not yet convinced overseas market participants that a reversal is actually imminent. This may not mean much, since Wall Street usually leads, but it is still noteworthy. Regardless though of whether a short term rebound has been signaled or not, we continue to believe that risk remains extremely high.

Just as treasuries have put in an ominous looking topping candle on very large trading volume in an already overbought market situation, junk bonds have done the opposite. This also argues for a pause in the wave of selling of “risk”. However, in line with our remarks above, this increase in volatility strikes us as a sign of increasingly unstable markets. We believe that the fat lady in fact has yet to sing, regardless of the short term bounce possibilities suggested by the above.

Addendum:

This morning we became aware of another article that nicely illustrates how complacency has replaced fear since 2009 (it is a very good bet that such an article would not have been written in 2009 – 2011):
A brief quote:

“Five years into an often uneven recovery, and with stocks more volatile, are the American economy and financial markets running low on gas?
No. In fact, the U.S. is in the early stages of an extended business cycle and a secular bull market for stocks that could last another two decades.
Compared with previous cycles, this new phase could be longer and more favorable to equities, the U.S. in general, and specific investment themes. Why? Because this is the beginning of a global recycling of growth.Unlike the past couple of bull markets, this recent upswing is not the result of speculative bubbles in credit, technology or real estate.”

Sure, the near-doubling of the money supply since 2008 never happened. We would charitably describe the above as delusional.

Charts by: StockCharts