A Rebound in Stocks Begins
Given that a very sharp downturn in so-called “risk assets” is well underway globally, but not yet fully confirmed by US big cap indexes, we are keeping an eye out for confirmation. This is to say, we are looking for events, market moves, positioning data, even newspaper headlines, that will either confirm or refute the notion that a larger scale bear market (as opposed to just a deep correction) has begun.
Haruhiko Kuroda will stimulate us back to Nirvana! Hurrah!
Photo credit: Yuya Shino / Reuters
Readers may recall an article we posted earlier this year, discussing historical examples of the stock market swooning in the seasonally strong month of January (see: “Stock Market Suffers Worst Start to the Year Ever” for details). When the market does something like this, it is more often than not sending a message worth heeding. Chart patterns of course never repeat in precisely the same manner, but such historical patterns are nevertheless often useful as rough guides.
As a reminder, here is a chart of the DJIA from 1961 to 1962. Both the distribution period preceding the sell-off, as well as the timing and pattern of the sell-off itself show many similarities to what has so far occurred in 2015 to 2016:
In keeping with this, we would now normally expect the market to rebound from the initial sell-off and retrace a portion of its losses over a period of several weeks before resuming the decline from a lower high. Last week the bond market delivered a technical signal on the daily chart, which based on well-known inter-market correlations suggests that such a rebound has likely begun.
Assuming that the positive correlation between treasury bond yields and the stock market (resp. the negative correlation between bond and stock prices) persists, the island reversal in bond yields last week is signaling the beginning of a short term relief rally. The bullish consensus in the bond market has recently become extremely stretched, so a rebound in yields would be quite normal – click to enlarge.
A certain degree of support for the idea has also emerged on the US economic data front: for instance, growth in retail sales exceeded expectations. More importantly though, initial unemployment claims, which traditionally are strongly negatively correlated with stock prices, fell sharply last week. In the process they have negated a recent short term uptrend that threatened to lead to a breakout to higher highs:
Crash Risk Still Remains High
There are of course a number of caveats to all of this: Neither the VIX nor put-call volume ratios have so far shown any signs of an emerging panic in the US stock market. If one looks at gold stocks, in spite of the sector being overbought and more than ripe for a pullback, numerous charts of individual gold stocks actually look as though they may have even more short term upside. Since the sector is currently negatively correlated with the broader stock market, this counts as a mildly negative factor for “risk”.
Moreover, as we have pointed out in a recent missive, once a market hovers close to major chart support – as is the case with the S&P 500 index and the DJIA at present – crash risk becomes higher than normal (see: “The Bubble Deflates and Crash Risk Rises” for the details). We would also point readers to John Hussman’s weekly market column, in which he echoes this sentiment:
“Given our focus on historically-informed, value-conscious, full-cycle investing, I generally don’t place much attention on short-term technical factors or specific patterns of price action. However, the current setup is one of the few exceptions. In a market return/risk classification that is already the most negative we identify, where a sustained period of speculation has given way increasing risk-aversion, the position of the market relative to very widely identified “support” (about the 1820 level on the S&P 500) is of particular note.
Often, well-recognized support levels become places where dip-buyers and swing-traders line up on the buy side, on the assumption that they’ll be rewarded if the market bounces from that support, and that they can quickly cut their losses immediately if the support level is broken. The problem here is that when too many speculators set their stop-loss points at the same level, and valuations are still elevated, there may be neither speculators nor value-conscious investors willing to bid for stock anywhere near those support levels once they break. The resulting gap between eager sellers at a high level and willing buyers at a much lower level is the essential element of market crashes, because every seller requires a buyer.
I’ve often observed that market crashes have historically emerged only after a familiar profile of market behavior that features a compressed market retreat of about 14% over 10-12 weeks, a rebound between 1/3 and 2/3 of that decline, a fresh retreat that slightly breaks that initial level of support, a one-day barn-burner advance, and then a collapse as the prior support level is broken. In the 1990’s, I called this pattern the lead-up to “five days of Armageddon” because historically, once rich valuations have been joined with poor market internals (what I used to call “trend uniformity”), the break of a widely-identified support level has often been followed by vertical market losses.
The present widely-followed “support” shelf for the S&P 500 is roughly 14% below the 2015 market peak, but most domestic and international indices have already broken corresponding support levels. Given the obscene valuations at the 2015 peak, my impression is that a run-of-the-mill completion of the current market cycle (neither an unusual nor worst-case scenario from a historical perspective) would comprise an additional market decline of roughly 40-50% from present levels. I certainly don’t expect that kind of market loss in one fell swoop. Rather, my immediate concern is that the first leg of this decline could be quite steep.
In other words, one shouldn’t get carried away by the market’s short term rebound potential. It exists, and it would clearly conform with “standard expectations”. We do assign a large probability to it. But the risk of a sudden and very sharp drop has definitely not gone away just yet.
Bear Market Confirmation from Japan?
Now we come to the what has prompted us to refer to “stimulus hopes” in the title of this post. With US markets closed for President’s Day on Monday, the mice came out to play everywhere else. Gold sold off sharply, and the Nikkei rallied by more than 1,000 points in a single trading day.
Normally people will be inclined to think that such a powerful reversal is a bullish sign. Unfortunately this isn’t the case – the opposite is true. Such rip-roaring one-day rallies are typically a hallmark of bear markets. Readers may recall that there have been a number of huge rallies in the DJIA a few years ago that broke records in terms of points recovered in the space of one to two trading days.
These notable moves occurred in September of 2008. After the SEC banned short selling of a large list of financial stocks in mid September, the DJIA rallied by more than 1,000 points in just two days. On the penultimate trading day of September it again rallied very strongly, recovering nearly 600 points in just one day. Then it crashed.
Record short term rallies in the DJIA before the October 2008 crash. Record one day rallies could incidentally also be observed in the three weeks preceding the 1987 crash and in April of 2000 – click to enlarge.
Note, we are not saying that a big one day rally means a crash is imminent. What we are saying is merely this: when such large short term rallies occur in the course of an initial wave of selling from a multi-year peak, they should be regarded as a bearish sign. This does not mean that a larger rebound cannot take shape over coming weeks. However, it does represent yet another warning.
This is especially so if one considers the headlines and circumstances accompanying the Nikkei’s surge on Monday. The Japanese government published yet another batch of terrible economic statistics. Specifically, the economy once again contracted in Q4 of 2015, for the fourth time in the past seven quarters. Here is how the rally in the Nikkei that started right after the release was explained in the mainstream press:
“Nikkei surges on stimulus hopes” wrote the Business Standard. Reuters reported: “Nikkei posts biggest daily gain in more than 4 months on oil bounce, stimulus hopes”. The Guardian noted along similar lines “Asian and European stock markets rally on stimulus hopes”. Countless similar headlines appeared all over the world.
Stimulus hopes? Seriously? Only a little while ago the press finally got around to noticing that the imposition of negative interest rates in Europe and Japan had backfired badly and was seemingly about to annihilate blind faith in central planners. We believe that absolutely nothing has changed on this front. The “stimulus” dog ain’t hunting anymore, even though we still come across declarations of faith such as this recent one by Deutsche Bank equity strategists, who asserted that “Only the Fed can Save Stocks Now”.
Well, no. It actually cannot – and neither can the BoJ or the ECB. It is a serious misconception to believe that central banks have “control” over what the stock market does next. There is a big difference between the ability to exert influence on the extent and duration of bubbles while they are underway and stopping a bear market from playing out.
People often end up losing a lot of money in bear markets because they believe that these things actually matter. Hopes are kept alive and as a result many people stay fully invested in the market at the worst possible time. Of course, in the aggregate these losses cannot be avoided anyway – after all, someone will always end up holding stocks. For every investor who manages to avoid further losses by selling, another investor steps up to the plate to take them instead.
We would assign a very high probability to a market rebound lasting several weeks, which would allow for oversold conditions to be relieved and recent positioning extremes in stock index futures to be mitigated. One must keep in mind though that nearby support levels will have to hold – if they are violated in the near term, the extant crash risk would likely materialize.
Regardless of the market’s near term gyrations though, the manner in which overseas markets have turned around on Monday should be seen as another medium term warning sign – not only on technical grounds, but also based on the faulty reasoning forwarded by market observers.
As we always stress, central banks definitely can goose stock prices even under the worst economic conditions, if they proceed to utterly destroy the currency they issue. This has e.g. most recently happened in Venezuela. However, our working assumption at this juncture remains that developed market central banks are highly unlikely to pursue such a course. After all, they all have “inflation targets” – and while they have obviously no control over price inflation either, we assume they will tighten policy should these targets be materially exceeded.
Pinning one’s hopes on “more stimulus” definitely strikes us as a mug’s game at the current juncture though.
Charts by: StockCharts, Acting Man