Deflation is in the air. It’s gutting the prices of raw materials, emerging markets, junk bonds and starting to catch up to equities.
It’s going to get ugly
The journey up was fast and fortuitous, without the structural economic improvements that should accompany such a prolific bull market. And more importantly, with enormous leverage and speculation driving prices.
The mini-panic on August 24, 2015 showed us that the market is capable of wild swings, and likely enormous drops. In 2008 we saw the stock market lose more than a quarter of its value in days. This sort of action is not only likely, but I expect it.
This level puts the index back to major area of psychological support and also seems to complete what may be a head and shoulders pattern forming on the S&P 500 back to the base of the left shoulder.
1,000 is a level where the market was before the latter incarnations of QE wildly distorted prices higher. I believe that the beneficial effects of QE were overestimated and that the detrimental effects underestimated.
The gross distortion of prices has destroyed many price signal indicators.Adding to that the lack of interest bearing savings account has forced savers to speculate, hoping for a gain.
The stock market’s valuation has largely benefited from corporate buybacks. Now corporations possess an enormous amount of debt.
Additionally, corporations tend to get cold feet as the market is volatile or when prices decline quarter over quarter. That means less buybacks should occur as fear overtakes greed.
Have some cash set aside
Right now my own inclination is to make a wish list of stocks to own and an idea of what prices make sense to buy them. Then wait for prices to come to me.
Rather than chasing prices or settling for buying something that may be overvalued I think it makes sense to set cash aside and buy in at lower prices. In all likelihood they are coming soon.
Reversals lower from a morning that began green often portend to more selling pressure in the coming days. Today was such a day in the US stock market. Prices opened strongly higher and closed decidedly in the red.
Reversals show a sentiment change
When buyers pile in the morning and exit with prices lower at the close than they were the previous day’s close, that indicates a change in investor confidence. Selling pressure exhausted the bid from buyers to the point that many buyers became net sellers. As a result equity markets went from being positive, to neutral and finally settling decidedly negative from the previous day’s close.
When this sort of change in confidence occurs it is often a multi-day or week event, rather than a one off. With the much cited Federal Reserve interest rate policy decision just about a week away, there is the potential for increased anxiety across multiple interest rate sensitive asset classes, including stocks.
Bears growl, bulls hide
For the first time since the correction of 2011 the markets are not seeing an immediate buy the dip rally that sustains itself to new highs.
Bears are wrestling for control over price direction with bulls. Each have differing opinions on stock valuations and are expressing them with their trades and investments. Where prices ultimately go will depend on whose convictions prove to be correct.
For now the bulls are retreating as the bears show their teeth.
At this point there is some distortion between energy and metals which have a direct relationship as energy must be expended to mine the metals. usually the ratio is 10x the price of a barrel of oil for an ounce of gold, but now it’s been in a range of 12.5x-15x.
Either oil is very undervalued (which is unlikely) or gold is overbought at these levels.
Today’s close of the stock markets and oil seems to indicative of a risk repricing that began last week.
960 (around the 50 day moving average) on the S&P 500 and $65 a barrel on light sweet crude are my downside targets short term, but if either breaks we could trade to much lower support levels.
In addition, when examining the huge sell off in natural gas prices, it’s near certain that energy has more negative catalysts than positive because industrial utilization continues to lag despite the green shoots propaganda that we keep hearing.
Finally, there are a growing number of bears calling for a shake out of March’s lows coming this fall because of a new leg down in commercial real estate that will bleed liquidity out of the equity markets and REITs.
A repeat performance of the bear market rally breakdown seems to be in the works now. The first downside target is 875, then I believe we could see a large sell off to around 775-800 if that level breaks. After that a retest of the lows is almost certain. The image below illustrates the pattern on a three month / one day bar chart. There may be some support at the 200 day moving average around current levels as the market is oversold. A bounce before continuing downward is not out of the question.
For the past seven weeks there has been an impressive, rip roaring 30% bear market rally from the March lows. There has been no fundamental reason or glimmer of hope that truly spells the end of this recession. Instead what we have are bank earnings that no one in their right mind can trust with the amount of accounting trickery taking place. Consumer credit card interest rates skyrocketing. Record foreclosures in both residential and commercial real estate. And a parade of uninspiring earnings and guidance from the S&P 500.
Room for gloom and doom
The market has been ignoring bearish news which could be viewed as bullish, except it is also ignoring the fundamental macroeconomic picture. Emerging markets in Eastern Europe and Asia are hard hit by the global economic crisis. Some are on the brink of default with their sovereign debt, forcing them to seek loans from the IMF. Others are rapidly devaluing their currencies. Either path demonstrates signs of extreme financial stress.
There is no end in sight to the problems with real estate, which led us in to this mess. We have yet to see a meaningful bottom in housing and now commercial real estate is suffering. GM is on the verge of bankruptcy with few alternatives and to top it off global GDP will likely shrink the first time in decades.
Froth at the top
On a technical basis the S&P 500 seems to be overextended. It has been overbought too quickly for most of the momentum to be sustainable. In the last week we’ve seen a lot of that momentum fall to the wayside. While consolidation is normal, we can’t with any confidence declare this as more than a bear market rally to which an abrupt and painful end may be in sight. The bank stress tests are expected to start being released to banks this Friday and to the public in early May. The old adage “Sell in May” could be a very meaningful pronouncement for this Summer.
Keep your powder dry
I recommend using this rally as an opportunity to raise cash, sit on the sidelines and wait for a good buying opportunity for the long term. Short term the best position is a short bias. I don’t feel that being constructive after such a massive build up, especially when some of the larger gains have been on light volume, is warranted. Possible support exists at 850, 830, 800 and 775. At this point it is conceivable that we also retest the lows in the 660s over the Summer depending on how severe some of the interim problems become.
Prior rallies during this bear market that hit the 50 day moving average have been rejected. This rally seems to be bumping below the 50 day moving average and is seeing that as an area of resistance.
This trend is important to watch because if the market decisively breaks above the 50 day moving average that will add to short term bullishness. If the market can not break above the 50 day moving average and slumps lower, that may be a sign that the uptrend is ending.