A short covering rally took the S&P500 index (TSP C fund) to its post-correction peak leading some to wonder if the correction is over. From our perspective, it is too early to assume all is clear but the charts look better than they did a few days ago.
In September the NYSE short interest reached levels not seen since the Lehman failure indicating extreme negative sentiment in the market. From a contrarian point of view, this could be considered market positive since all those shorts need to cover (buy stocks) if the market is given some reason to rally. As usual they got it from the Fed and the weak economy.
It appears the Fed’s confused statements (leading to a market decline and more shorting) was finally cleared up with what we really meant to convey was how ultra dovish (chicken) we are when it comes to ever raising interest rates. Then we got the “bad is good” jobs report which cemented in the market’s collective mind that rates might not actually be raised this century.
The “bad is good” effect has become so pronounced that even the mainstream media has begun to ask why the stock market soars when bad economic news hits the wires. The short answer is the financial markets are not correlated to the economy and are instead addicted to the easy money policies of the Fed.
Currently the markets have merely returned to overhead resistance. The S&P 500 appears to be working hard to penetrate the first line of overhead resistance, but if it does it would soon find the next level of resistance. The markets spend more time at overhead resistance levels than anywhere else.
The markets rapidly move between support and resistance, bounce quickly off support, but linger at resistance. The last time they broke through a strong resistance was when the ECB announced its QE program. This has me believing we will not see new highs until the Fed reverses policy completely (they are ultra dovish, so it could happen).
The non – S&P 500 stocks (TSP S fund & VXF ETF) look weaker and have more resistance to work through. The rising wedge pattern I discuss in a previous post was a continuation pattern of the recent decline and took the smaller cap stocks to a new low, but the S&P500 came up short of the classical pattern’s downside prediction and held at the market’s previous lows.
When the stock market rallied last Friday, I was surprised to see our favorite measure of investor aversion to risk did not recover and diverged significantly from the stock markets action. This was highlighting that the rally in the stock market was initially based on short-covering (buying to cover downside bets) and not a growing appetite for risk by investors as seen in the next chart (Source: FRED is the Federal Reserve Economic Data).
In order to confuse my readers, I un-inverted our credit spread measure in the next chart so that a rising trend equals rising aversion to risk. I have also plotted a small cap stock index since risk preference in the stock market is usually indicated in the small caps first. The chart shows the small cap index traded sideways for an extended time prior to the ECB launching their QE program that led to a small risk-on rally in the markets prior to returning to the previous sideways range.
If you look at the far right of the above chart, we see credit spreads (black plot) are finally coming down during the current stock market rally but remain well above their trend line. We are in a waiting game to see if the trend of investor aversion to risk remains intact (negative) and if the stock market can work its way through overhead resistance.
In my opinion we need more than bad economic reports and dovish announcements from the Fed to meaningfully change the trend in investor aversion to risk. We are currently seeing a global relief rally in many markets that were deeply oversold based on a weaker dollar (due to our weaker than expected economy). The market does respond positively in the short run, both a weak economy and easy money policies are market negative in the long run.
My last statement on easy money goes counter to conventional thinking. I have longed believed zero interest rates are a drag on the economy as the households that matter the most are losing unearned income. Rational people feel they need to save more today to make their retirement calculations work out at lower yields. In other words they are spending less today, and trying to save more to make up for lower expected returns in retirement.
Unfortunately, the Fed’s models only see you as “consumers” who will spend more with lower interest rates. I was happy to see Deutsche Bank’s Binky Chadha (senior global strategist) look at the relationship. You can read about it in the Fiscal Times article People weren’t supposed to be saving this much money — and now it’s a problem.
Read it twice since it flips most analysis on its head. We need higher interest rates (not lower) to help the economy! But the financial markets the Fed is entranced with don’t want higher rates and will falter badly if policy is corrected. The financial markets may falter anyway not unlike how a balloon does not need a pin to pop if you just keep blowing into it (yes I know this sentence has three negatives). We may be at that point already.
The primary question for investors in today’s environment should be, “are we in a protracted correction or have we started the 1st leg down in the next bear market”. While both situations can play out the same over the next few months, the final outcome for the two situations is quite stark. I recently posted our Fall Summary report for members. We take a look at a broad group of indicators and how they correlate to market cycles. I think you will find it helpful.
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