Gray Swans and Black Swans
By Monday’s close, the S&P 500 Index was closing in on the low established in the August swoon – such a retest was essentially our minimum expectation, as V-shaped rebounds are very rare. The question is now whether it will only be a retest, or if something worse is in the offing. No-one knows for sure of course, but we’ll briefly discuss what we are looking at in this context.
Image via NYTimes
It is interesting that as the market has declined in recent days, the news-flow accompanying this move has steadily worsened. This is fairly typical for downward trends: suddenly the frequency of bad news increases, and more importantly, suddenly bad news seem to matter. Not only have economic data releases generally been weak regardless of their provenance (yesterday: China’s manufacturing PMI, Dallas manufacturing survey), but assorted black swans, or at least “gray” swans are suddenly popping up left and right.
An example for a recent “black swan” is the emissions scandal surrounding Volkswagen (VW). We don’t want to discuss the merits of this case at this juncture (we will soon have more to say about the matter). What is important in terms of the financial markets is that VW is a pretty important company in Germany, in fact it is one of its largest employers. As such, it is important for all of Europe. VW’s woes have helped to cement the erasure of Mr. Draghi’s “QE effect” on Germany’s stock market, which was already well underway before the scandal broke.
Another “black swan” are the concerns that have suddenly been raised about Ms. Yellen’s health (see Mish’s discussion here), after she faltered about 50 minutes into a speech delivered at Amherst University. Ms. Yellen no doubt has to deal with a lot of stress and she is no longer a spring chicken. It may be that these were burn-out type symptoms, or perhaps the event was just a sign of short term exhaustion, which she will quickly recover from (we certainly wish her all the best). Anyway, given the general backdrop, this is something that probably worries the markets, even though no-one has publicly mentioned this aspect as far as we can tell.
Then we have the “gray swan” Glencore – the commodity trading house that bought mining firm Xstrata at the top of the cycle (a not too brilliant move in hindsight). Zerohedge has been detailing the company’s woes (here is some more color). In brief: Glencore is a problem for the markets because it is one of the world’s largest commodity traders. In other words, it represents potential counterparty risk, and much hinges on its credit rating remaining in “investment grade” territory – if it gets downgraded, it could easily trip over rising margin requirements.
In this context it is not exactly comforting to know that the company has $30 bn. in debt, that CDS spreads on its debt are soaring into the stratosphere (indicating a 52% default probability as of yesterday at the standard recovery assumption of 40%) and that its stock is in complete free-fall (it recovered slightly today). You get the drift – this development wasn’t totally unexpected (hence a “gray” swan), but it certainly comes at a bad time.
Glencore’s stock price has utterly collapsed. If this company were to keel over, its shareholders would definitely get nada. As it is, they can at best expect massive dilution as the company will need to raise more capital to survive – click to enlarge.
Such a crescendo of bad news-flow often coincides with short term lows of course, but one never knows: it is always possible that something else happens in addition and tips the markets over the edge.
Divergence Watch – What to Look For
Readers may have noticed that the tech-heavy Nasdaq has begun to underperform the rest of the market in recent days – mainly due to a sharp 20% decline in the biotech index, which has plummeted seven trading days in a row. This is usually a bad sign, as the Nasdaq is one of the leading indexes and is moreover where all the longs have been hiding out of late. Below is a chart of the Nasdaq/SPX ratio that shows the deterioration in relative performance over the past few days:
However, we actually think it is even more important to keep a close eye on the small cap index Russell 2000 (RUT). Over the past two years or so, every correction has been led by the RUT and has ended when its performance started to diverge positively from the rest of the market. It is leading this time around as well – in fact, it has already violated its August lows:
Conversely, a bounce in the market that is accompanied by relative RUT weakness will lack credibility and should in our opinion be distrusted.
Short Term Sentiment and Volatility Indexes
As an illustration of short term sentiment, one can look at the equity-only put-call volume ratio as a fairly reliable gauge (it is a contrary indicator). This ratio has naturally spiked in recent days and has ended at a fairly highish level of 94. This is sometimes high enough to indicate a short to medium term low is imminent, but occasionally such levels are exceeded. They certainly will be in a true panic sell-off.
Putting the above mentioned put-call ratio into perspective is the VIX, the chart of which still looks oddly bullish. Admittedly there are limits to the usefulness of technical analysis performed on a derivative of a derivative like the VIX, but it actually seems to respect lateral support and resistance levels:
Note: the VIX is also apt to put in a positive divergence in the context of a successful retest of previous lows. So this is another indicator one needs to watch closely – its current level in fact indicates that a positive divergence is likely to happen.
As a general remark: one should not get distracted by one or two day moves. A rebound today may actually not mean much (it would be more meaningful if it were preceded by a positive RUT/SPX divergence in which the RUT exhibits relative strength). There is of course no hard and fast rule that says things have to play out in the same manner every time, but it is always useful to be aware of what has happened on similar occasions previously.
Should several of the most important indexes close well below their August lows in coming days (i.e., by approx. 3% or more), the “crash danger” will become extremely elevated.
Junk Bond Yields are Breaking Out
Lest we forget, another major warning sign is currently provided by junk bond yields, which have broken above their previous highs:
Yields on the “best” and the worst junk bonds: BofA Master Index II, and US CCC and below. Both have broken out to the upside. Note that junk bonds have been deteriorating for quite some time – a strong sign that the recent swoon in the stock market is more than just a routine correction – click to enlarge.
The higher probability bet is always that a retest of a previous low that occurs in the September/ October time frame will be successful. However, there are exceptions to this general rule of thumb and although they are rare, they also represent potentially highly damaging, resp. profitable occasions (depending on how one is positioned).
There are certain things one should look for when assessing these probabilities, and technical analysis, especially the analysis of divergences can be very helpful in this respect. It is clear that the current juncture is potentially quite dangerous – should yet another one or two weighty black or “gray” swans make an entrance, things could easily go haywire given how close to support the market currently is.
We would add to this that even if the retest of the August lows should turn out to be successful in the short term, it will not tell us anything about whether or not the long term trend has changed. We believe that chances are very good that it actually has changed and that a bear market has begun, but as always in such situations, one cannot be absolutely certain about this just yet.
What makes us think so is that the long term indicators we follow are all deep in “red alert” territory (i.e., valuation, sentiment and positioning indicators). This will always begin to matter at some point, and that juncture may well have been reached.
Charts by: BigCharts, StockCharts, St. Louis Federal Reserve Research