Asia “Not Helped” by Chinese Data, Fed Officials Back-Pedaling

We wanted to see if there were any signs of concern in the mainstream financial press over the recent market decline (which is still small in terms of the major indexes, although this can no longer be claimed of the “average stock”).

We would characterize the mood as one of “mild concern” – generally it seems to be held that the decline is just another of the periodic (and ever smaller) corrections we have seen over the past few years. It is noteworthy though that the recent decline is referred to as a “growth scare”. For instance, Reuters reports on overnight weakness in Asian markets – which actually didn’t entail any overly big moves:

“Asian stocks stumbled to seven-month lows on Monday, while crude oil prices were pinned near a four-year trough as promising trade numbers out of China failed to cheer a market still worried about faltering global growth.

MSCI’s broadest index of Asia-Pacific shares outside Japan fell 0.8 percent, extending last week’s 1.1 percent drop. Mainland Chinese stocks skidded 1.1 percent and Hong Kong’s Hang Seng shed 0.7 percent. Australia’s S&P/ASX 200 index and South Korea’s KOSPI both slipped 0.6 percent. Tokyo’s Nikkei was spared the pain for now thanks to a public holiday in Japan. The declines in Asian markets came after U.S. stocks skidded 1.2 percent on Friday and Wall Street’s fear gauge, the CBOE Volatility Index, jumped to a near two-year high.”

There may be worries about global growth, which is indeed not much to write home about in recent months. Surely though the biggest worry in the background must be the idea that the Fed’s monetary policy will be tightened further. It is already all but certain that “QE” will end this month, and the next logical step would be an attempt to hike rates. It may well never come to that however. The back-pedaling is beginning already:

“Underscoring the gloom surrounding the euro zone, Standard & Poor’s on Friday slapped a negative outlook on France’s sovereign ratings, topping off a difficult week that featured a string of worryingly weak German data.

European Central Bank President Mario Draghi last week said a slowdown in the euro zone’s economic momentum could weigh further on the reluctance of companies and households to invest.Draghi reiterated that the ECB Governing Council was unanimous in its commitment to using additional unconventional instruments within its mandate to address risks of a too-long period of low inflation.

Several Federal Reserve officials, most notably, Fed Vice Chairman Stanley Fischer, said on Saturday efforts to normalize U.S. monetary policy after years of extraordinary stimulus may be hampered by the global outlook.”

(emphasis added)

In the short term the markets may well find some solace from Federal Reserve officials sounding more dovish again (it is astonishing what one bad week in the stock market can do), but it is important to realize that once an overvalued market gets into trouble, policy measures cannot keep it from going down. If they could, there would never be any bear markets. Nor would there ever have been crashes, but we have obviously seen several of those over the past 25 years.

On Friday, the S&P 500 landed at what seems a logical short term support point, namely its 200 day moving average – which it hasn’t visited in quite some time. Volume continues to expand, but remains less than panicky so far. The downside leader Russell 2000 is still leading. The decline is nothing special so far, and while various fear gauges have been rising, they still remain below extreme levels.

The S&P 500 and the Russell 2000 – click to enlarge.

A Semiconductor Hand Grenade

On Friday, the hitherto relatively strong technology sector was hit the most, a move apparently inspired by a negative earnings surprise in the semiconductor sector (the culprit du jour was MCHP – Microchip Inc., which lost over 12%). This is an interesting development due to the sector’s cyclical nature. The fact that it led the technology sector lower is no doubt a reflection of the global economic slowdown and underscores the “growth scare” idea.

Nasdaq Composite and the SOX Index. The SOX merrily gapped into the abyss after MCHP’s earnings miss – click to enlarge.

The important thing in this context is that the US economy, due to representing a very large domestic market, is an economic region that occasionally manages to “decouple” a bit from the rest of the world. However, the same cannot be said for the earnings of companies that have significant overseas business.

In other words, there is a chance that the previous “virtuous circle” could temporarily turn into a vicious one. The virtuous circle was driven by the idea that the economy was strengthening, while the Fed remained ultra-easy anyway. This idea could to be transforming into a mixture of a growth and a tightening scare. Consider in this context the importance the Fed attaches to a lagging economic indicator, namely employment. If the unemployment rate continues to decline, the Fed likely won’t veer off its current course toward tightening just because the stock market is correcting – unless the correction becomes something worse.

A Trend Change In Junk Bonds?

It may be a bit early to come to a definitive conclusion, but as the Merrill High Yield Master 2 yield and the Merrill CCC and lower effective yield charts show, we do have a few initial signs of a trend change:

Merrill High Yield Master 2 effective yield. In mid 2014 an all time low in junk bond yields was hit. Since then, we are seeing the first signs that a trend change might be underway – click to enlarge.

CCC and lower rated yields recently suffered an even bigger spike – which underscores the fact that these are not really very liquid markets – click to enlarge.

As we have previously pointed out, since banks are no longer really making markets in corporate bonds (due to reducing their proprietary trading as a result of post crisis changes in regulations), the risks in these bond markets may be higher than is generally appreciated. The problem is that liquidity isn’t what it once used to be. The recent temporary spike that can be seen in the chart of CCC yields above looks like a warning shot in this respect.

Sentiment

When prices decline, sentiment and positioning data tend to follow suit – these data must therefore always be seen in context. Below we show an update of Rydex asset data. What strikes us as noteworthy is not that bull and sector assets have declined somewhat and money market funds have experienced a small increase. This is normal and should be expected when the stock market suffers two weeks of declines.

What is noteworthy is rather that there have still been no inflows into bear funds. In other words, while upside bets have been reduced, there seems an extreme reluctance to bet on declining prices. This is eerily similar to the 2000-2001 period, when bear assets only began to move higher once the bear market had already been underway for quite some time. The parallel to today is of course that prices had been rising so relentlessly for so long that bears have become extremely careful.

The S&P 500, Rydex asset ratio (bear + MM assets/bull assets – inverse scale), total bear assets, MM funds and total bull and sector assets. The timidity of the bears remains the most remarkable feature of this chart – click to enlarge.

Conclusion:

A number of major indexes have reached or slightly undercut their 200 dma’s. If the recent decline is just another routine pullback, this is where they should normally reverse. Note that even if there is a short term reversal, it needs to “stick” to be valid. If the market’s continues to exhibit behavior that is different from that we have observed over the past two years, it will be another sign that something more than just a routine correction is underway. This risk continues to strike us as relatively high at the current juncture.