A Classical Rebound from Oversold Extremes
Beginning on Wednesday last week, the stock market started a rebound from extreme oversold conditions that was just as volatile as the sell-off that preceded it. Such a rebound was to be expected, but unfortunately it cannot really tell us what is likely to happen next. In the meantime, the S&P 500 Index has reached a first level of resistance, so we should soon know more.
A secondary lateral resistance level is a little further above, and is likely to be reached if the first one gives way:
Sentiment and Positioning Data
All sorts of extreme short term readings were reached around the lows, and last week was inter alia marked by numerous “selling climaxes” (i.e., stocks reaching new lows for the move, and then ending the week above the levels they started it at). Nevertheless, several short term indicators eased off from their extremes and the short term optimism indicator briefly went all the way to its opposite boundary (“extreme optimism”), but then dipped back again on Friday:
Many options-related indicators have basically ended the week in the middle of their recent ranges as well, but it is worth noting a few details in this context. For instance, Mish reports that put premiums in Shanghai have reached record highs against call premiums in recent days. He rightly points out that this is a contrary indicator, except if a crash wave is underway. The Shanghai Composite hasn’t made much progress yet from its lows:
If the “normal” interpretation of the options skew in Shanghai is applicable (which has to be accorded the higher probability), then Chinese stocks should soon begin to exhibit some strength in the short term.
In the US markets, we see options-related data at levels that are historically high, but only middling compared to recent extremes. To this we would add a personal observation: we are closely watching short term options on leveraged ETFs (we don’t recommend playing them – it is an activity on the gambling side of short term trading. Then again, we like to play poker too). A major factor in the decision-making processes involved in trading these options are both absolute and relative option prices. As of Thursday/Friday last week, short term option bets on a rising market (puts on inverse ETFs, resp. calls on bullish ETFs) were still much cheaper than equidistant (in terms of strikes) option bets on a falling market (i.e., calls on inverse ETFs/ puts on bullish ETFs). In other words, the cost of hedging and/or downside speculation remains high on a relative basis, even if it isn’t as extreme as in Shanghai. Again, this doesn’t matter if the market is about to crash (or if price-insensitive players are forced to sell based on mathematical models). Normally it would indicate though that a bounce has further to go in the short term. The large size of the spike in the VIX recorded last week was probably mainly due to the element of surprise and the speed of the decline, but the VIX definitely reached a historically high level that has only been materially exceeded in major crashes.
The VIX index over the long term; the index measures volatility premiums on SPX options. The recent spike high is comparable to a number of historical spikes, with the exception of outliers such as 2008 (and also 1987). The pullback to the current level of 26 could however well turn out to be of the short term variety and be followed by additional spikes – click to enlarge.
The equity put-call volume ratio has returned to the 70s, a high level in a “normal” market, but currently probably not overly meaningful. In fact, it can be seen that option traders were already suspicious of the market before the “mini crash” (and rightly so):
Ratios and Internals
Lastly, here is a look at a few intra-market ratios, comparing the strength of major indexes. These ratios have behaved in a manner that is highly reminiscent of the late 1990s. Note that there are no hard and fast rules as to how far apart the relative strength of narrow and broad market indexes can drift. For instance, ahead of the Asian/Russian crisis, market internals and relative strength indicators had also warned of trouble, and while trouble did indeed ensue, the market subsequently rallied even further and the imbalances continued to increase.
The big cap tech stocks that are the main drivers of the Nasdaq have far outpaced the broader market as represented by the NYA. The relative strength of the Russell 2000 has improved between the October 2014 low and late June, but since then has begun to drift lower again – click to enlarge.
Here is a look at the current state of the market internals we have last discussed shortly before the mini-crash:
Naturally these internals have deteriorated further, but at the same time they have reached short term “oversold” levels. Their rebound strikes us as fairly weak though – a great many stocks remain below both their 200 and 50 day ma’s for instance, which is testament to the fact that most stocks were already quite weak long before the major indexes gave way.
It seems likely to us that the hitherto weakest market sectors are probably going to be the greatest beneficiaries of any rebound attempts, simply because e.g. commodities have become so cheap on a relative basis that they seem poised to rally in the short term. In fact, shortly after we considered the bounce potential of crude oil and industrial commodities – here and here – these markets have begun to bounce as well.
What cannot be known is whether these rebounds are the beginnings of a larger retracement move or if they are merely relieving oversold conditions in ongoing bear markets. There is usually little/nothing that differentiates the two types of rebounds in their initial stages. We well simply have to wait whether there is follow-through, but if the Shanghai Composite were to see a larger retracement of its decline, it would be a good bet that the same would happen in industrial commodities.
Unless price-insensitive sellers interfere or the news backdrop deteriorates significantly again in the short term, the stock market could push to the next resistance level before reversing again. However, it is now already at the first resistance level, and nothing has changed yet about the broader market’s relative weakness. In addition, a recent sharp decline in margin debt is ominous given historical precedent (often major peaks see a sharp dip in margin debt after a preceding strong rise):
NYSE margin debt dips sharply by around $17 billion. Such a sudden decline in margin debt close to a market peak is often, but not always, a warning sign (the 2011 dip didn’t mean much for instance) – click to enlarge.
Margin debt obviously remains extremely high, and nothing of consequence has as of yet changed with respect to any of the other longer term indicators we have previously discussed (such as mutual fund cash and the retail money market fund ratio). So the long term signals remain on “red alert”, regardless of the direction of the short term trend.
We should also point out that inter-market correlations aren’t set in stone. It is not necessarily the case that a rebound in commodities has to go hand in hand with a rebound in the major stock indexes, even though it seems likely based on very recent correlations (keep in mind though that commodities have been declining since 2011 while the stock market has kept rising, so a positive correlation is a fairly short term phenomenon even by recent standards). In fact, even well-worn correlations often end without warning. We mention this not least in connection with the below observation on German Bunds. Considering the recent weakness in stock markets, the action in government bonds of developed countries has been remarkably poor. This could be an early warning sign that inflation expectations are close to reversing (and that would surely surprise most market participants).
Addendum: The Odd Behavior of Bund Yields
We are always keeping an eye on European government bond yields, and the chart of the 10-year German Bund yield looks somewhat ominous to us – in other words, the chart currently looks bullish (for yields), which is to say, potentially quite bearish for Bund prices:
Charts by: StockCharts, SentimenTrader