Why are stocks selling off?

First let’s dive in to the mechanics of what’s changed. We were accustomed to a market where there was practically no volatility. Complacency was high and on a technical basis the Dow and S&P were more overbought than at any period since perhaps 1929. In essence euphoria and perhaps even blind optimism were becoming extreme. That condition quickly and violently reversed as more than five trillion dollars of market capitalization have been wiped out by selling since January 26th, 2018.

Volatility has returned

We’re now seeing volatility pick up and equities give back much of their gains over the past several months rapidly. Downward moves are generally faster paced and more intense than moves upward. Easy come, easier go.

That relatively uneventful journey up in most of 2017 is part of the problem with markets right now. During the rise in prices equities didn’t consolidate or correct which led to almost no technical support for buyers.

This is important because when there is volatility, market participants often utilize charts and technical patterns to determine areas of support. But in moves that are parabolic there generally aren’t such areas of technical support on the chart to rely on. So buyers (both human and bots) are more shy to put a bid out.

Fear is a powerful emotion

When volatility picks up and losses accumulate, speculators that used leverage (debt) to buy equities are often hit the hardest, forced to liquidate their positions. When this sort of activity crescendos with other investors panicking we typically see a capitulation selling event. I’m not certain we’ve seen that event as of yet, though. The market will have to demonstrate whether or not it has buyers here.

An example of how powerful fear can be is how inverse volatility index (VIX) ETFs have imploded in the wake of volatility returning to markets, meaning buyers who bet against intense trading price ranges were essentially wiped out. This trade worked well for years — until one day it didn’t.

These dislocations are not enough to create a full on selling panic on their own. Instead they are representative of instruments that were too heavily bought in to on the long side unraveling as the markets normalize to higher levels of volatility.

Bots are not buyers during sell-offs

High frequency trading bots have overtaken humans as the largest component of buying and selling volume for US equities. That seems efficient in theory, but the problem we see is when the selling intensifies the bots stop bidding. That allows declines to intensify as those wishing to exit will be fighting against a larger spread and less buy-side liquidity.

Indeed, during the last week we’ve seen situations where smaller lots were moving markets up and down by handles, rather than ticks. That’s the sort of activity one expects in an illiquid and immature market. Yet we are seeing it on a continuing basis here in the US with its extremely deep and previously liquid stock markets.

Technically speaking

Zooming out to a 30,000ft perspective, we haven’t seen any truly significant selling. Even though many points have been lost on major indices, this selling event is relatively normal. The pace of it is a bit intense, but for a maturing bull market one should expect increasing volatility along with leadership consolidation.

S&P 500 technical analysis

The S&P 500 appears to be hitting a lower area of support. Watching to see whether cautious buyers come in for a move more substantive than a “dead cat bounce” is crucial in determining whether or not the downward move is ending or if there is more to go. If we move meaningfully down from here across the US equity indices I believe we are going to see much more significant selling pressure and volatility.

It’s almost entirely about rates

The selling intensity and loss of confidence in bidding up equities seems to be tied to increasing rates on the longer end of the yield curve. Related to that development is that inflation expectations are beginning to change and concerns are rising. That is to say, bond buyers may be questioning whether a 10 year bond at 2.851% is a fair interest rate or if perhaps a higher rate is justified based on what the rate of inflation may be over the next 10 year period. If buyers commit to an interest rate that is lower than inflation they walk away with a loss when the coupon matures.

While the yield curve has had a flattening spread for several years — it is beginning to steepen again. Higher interest rates are also inducing higher borrowing costs for mortgages, margin debt as well as other variable rate debts and could compress consumer spending as well as market buy-side participation. Borrowing costs are one of the most important factors in market psychology as well as interest earned on presumably safe government bonds.

That means if the 10 year bond continues higher, say at 3% or more, then many equity participants may re-balance their portfolio away from equities and more towards US Treasury bonds. Assuming other shorter dated bonds were not as well bought, that change would steepen the yield curve which would also potentially assist lenders in capturing a larger interest rate delta between the short term borrowing they engage in vs. the long term lending at higher rates.

On the other side of that, if yields peak and meaningfully decline then there is a fair chance that a bid returns to the equity markets and they move meaningfully higher. Whether or not stocks are able to make a higher high in prices is the most important technical consideration for maintaining a healthy bull market uptrend.

Economic development trajectory

If economic data begins to slow meaningfully, which it may with higher rates, that is another area where weakness may be demonstrated as a result of reduced economic participant confidence. Such slowdowns often happen as rates increase and borrowing costs rise at the end of a business cycle. The most leveraged companies, states, cities and private debt holders are hit the hardest.

Closing thoughts

As I told a friend, the “crisis” now is that there is a lack of a crisis to keep crisis-level accommodations flowing. In essence the central bank liquidity spigots are slowing and commercial lending is taking a breather. The Fed has also recently made it clear that the “Powell Put” is at much lower price levels.

These developments impact both equity markets and real-world economic activity.  I’ll be watching the economic data releases, interest rate complex, especially 10 year yields and junk bonds, to see where equities may go from here.

Gold’s 2015 performance in various currencies (chart)

The Brazilian Real was walloped and the dollar was clearly a standout winner. Gold’s relative underperformance shows against US dollars that the US dollar is still seen as a safe haven currency.

Until that changes gold will underperform as measured by US dollars. I think we’re closer a that point in time when we see positive price action then we were a year ago, but I can’t say for certain if the markets will agree until stocks move in to a bear market.

As seen in the start of 2016, when stocks were out of favor, gold caught a bid and moved higher each day stocks were sold off. Now that stocks are catching a bid, gold is selling off.

Whether or not 2016 is the year that stocks enter a bear market remains in question. I am inclined to think that we have only seen a prelude for the downside in stocks that could occur this year.

Crude oil surges above resistance in historic move; bear rally or interim bottom?

This could be a bear market rally or the makings of an interim bottom in WTIC.  Either way it is a huge reversal.  Last night the WTIC futures were down almost 2% and today prices are up 7.16%  That’s nearly a 10% swing reversal in a single trading day!

My thoughts are as follows:

1: The Sauds will run out of capital if they keep pumping excess supply in to the market.  I believe they are working to curb the oversupply situation by limiting their contribution.  I also feel that OPEC will mirror this move.  The Saudi idea that they could curb the activities of their competition was met with the reality of 0% interest rate policy here at home keeping it cheaper to sustain than to stop all operations.  With all that in mind, prices below $40.00 are unlikely to remain so for long unless China goes in to a full blown recession.

2: We’ve now neutralized the oversold condition on spot WTIC prices and are back above the relatively key level of $45.00.  This is an area where there has been significant support in the past.  I expect it may act as support again if we see selling pressure.  It would also make sense to see some backtesting/consolidating here, perhaps back to the 20 day moving average around $43.10 (which is also where several key price support areas have been).

WTIC-2

3: As we’re above $45.00, the next major level of resistance is quickly approaching at $49.01 (50 day moving average). If we are able to make a rally above $49.00 with large volume, then I’d be tempted to say we’ve put an interim bottom in place.  That said, “V” shaped bottoms are rare, so a re-test of lower levels first is very likely unless this is merely a bear market rally.

4: The latest sell-off started when there was a ‘death cross’ of the 50 over the 20 day moving average — and ended with a waterfall decline to about $38.00.  At that point the relative strength index was under 20 and extremely oversold.   Now we are looking to challenge the 50 day moving average from below with relative strength showing the buyers are not exhausted yet.

Truly exciting times in commodities markets.  I can smell the panicked short covering today.

Trend support broken on S&P 500 index

Stocks are selling off — and fast.  But what exactly is a price trend and what do they look like?  Trends are defined as a series of higher highs and higher lows for an uptrend and a series of lower lows and lower highs for a downtrend. Uptrends are the result of more buying than selling for a given period of time while the inverse is true of downtrends.  An uptrend is essentially a chart where the price starts on the lower left and ends on the upper right.

After the S&P 500 consolidated for about a year it has decidedly turned much lower — and quickly.  With the worst three point day rout in the Dow since its inception behind us now, what is going to happen next?

First, I think it’s important to note that while I believe the trend remains down, there is likely some sort of bounce that will come soon.  Think of it as a moderating bounce.  One where we see some positive price action to push things off the extreme lows and encourage some buying.  After all, across just about every measure on the short to intermediate term, stocks are oversold.

damagedWe’re overdue for a bounce, but what follows may be a trounce.

That being said, it’s most likely that such a wave of buying will be short lived and followed by additional, deeper selling.  The reason I believe that this is the case is that the main catalysts that have driven the market higher, as discussed in my previous article, are largely drying up.  While at the same time, the global picture seems to be much more grim.