Stocks - Biggest Reversal Since March 2009

Stocks - Biggest Reversal - Continue Rallying On Tuesday

Stocks continued their rally off the Christmas Eve bottom on Tuesday as the S&P 500 increased 0.97%. The S&P 500 is now up 9.5% from the Christmas Eve low.

Many prominent technical analysts would probably tell you stocks can’t bottom on a low volume day like Christmas Eve. Rules of thumb don’t always work out. I remember when traders claimed oil prices couldn’t top in the pre-market.

However, oil topped at $148 before the market opened in 2008. The only timeless advice is to stay nimble.

S&P 500 is now up 2.7% year to date. The market is already getting close to some people’s projections for full year returns. This solid January is similar to last year. A major difference is sentiment isn’t euphoric. It’s still recovering from the extreme bearishness at the end of December.

Stocks - Biggest Reversal Since March 2009

The chart below does an amazing job of showing how quick the turnaround in stocks has been.

It shows the McClellan oscillator. The last time this oscillator went from -80, which is extremely oversold, to +80, which is extremely overbought, in 2 weeks is March 2009.

This doesn’t mean the stock market is about to go on another bull market run of over 9 years. It just shows how severe the action was even though the total decline was much less than the previous bear market.

Stocks - Biggest Reversal - Details of Tuesday’s Action

Not all indicators agree with the McClellan oscillator that stocks have become overbought.

CNN Fear and Greed index is at 24 which is the edge of extreme fear. S&P 500 has been in this category for weeks. I think it will exit this category this week. Nasdaq increased 1.08%, the Russell 2000 was up 1.51%, and the VIX fell 4.35%.

Small caps underperformed during the bear run because they have high debt levels. They are vulnerable to high interest rates which is why they peaked earlier than the overall market. They are also vulnerable to weakness in financial conditions as they will face a tough time rolling over their debt.

All sectors were positive on Tuesday.

The best 2 sectors were real estate and communication services which increased 1.78% and 1.58%. Amazon stock is up 23.26% from its Christmas Eve low. KBW regional bank ETF is up 12.23% in that time frame. Regional banks were excessively beat up as they fell 32.74% from peak to trough last year.

That’s why going long this index is my trade of the year.

Stocks - Biggest Reversal - Yields Have Been Increasing

Treasury yields have been increasing in the past few days as traders have begun to price in a more optimistic growth scenario. This could just be a temporary trend correction. I think it’s possible for yields to be suppressed while stocks rally slightly.

That’s because economic growth will probably be weak in the first half of the year, but stocks still are reasonably priced if earnings growth is in the mid-single digits this year.

The 10 year yield bottomed at 2.55% on January 3rd. That’s a crazy yield because the Fed has guidance for the Fed funds rate to be between 2.75% and 3% by the end of the year.

Few investors believe the Fed, but it’s still amazing to consider the possibility that the 10 year yield could be that far below the Fed funds rate if the Fed executes on its guidance.

The 2 year yield bottomed at 2.38% on the same day. That’s only 11 basis points above the current effective Fed funds rate.

It’s interesting that at the near term bottom, the difference between the two bonds was 17 basis points. That’s steeper than the low for the cycle.

Some traders may have prematurely seen this modest steepening as a sign the economy was falling into a recession because the curve steepens at the start of recessions. A big problem is the economic data doesn’t support a recession in the next few months.

The current 10 year yield is 2.72% and the current 2 year yield is 2.58%. This means the difference between the 2 is 14 basis points. I expect an inversion in the next 5.5 months. I don’t expect traders to panic again when this inversion occurs unless the economic data starts to crater.

Stocks - Biggest Reversal - Fed Fund Futures

Much was made about the Fed funds futures market earlier this year because it showed the market expected rate cuts rather than hikes like the Fed projects.

Currently, the Fed funds futures market shows there is a 67.5% chance rates stay the same by the end of the year. There is a 23% chance of at least one rate hike and there is a 9.5% chance of at least one rate cut. I think there’s a small chance the Fed sneaks in one more hike.

If the economy starts to turn around, the Fed could follow through on its guidance. However, that’s not likely based on the ECRI leading index.

Stocks - Biggest Reversal - Very Weak Leading Index

As you can see from the chart below, the ECRI leading index is down 5.3% year over year which is approaching a 7 year low.

Good news is the year over year growth comparisons will start to get easier in the next few months. Bad news is the overall index is still declining, meaning it’s not comparisons causing this weak result.

This reading suggests the economy will get weaker in the next few months. That will prevent rate hikes this year. If this index finally bottoms, I will be extremely bullish on stocks.

Now all I can say is stocks are a buy in the short term, and they won’t crater this year unless there is a recession because multiples contracted so sharply in Q4 2018.

Stocks - Biggest Reversal - Conclusion

Powell seems to have pulled back from the hawkish December Fed meeting.

However, the Fed still has guidance for 2 hikes this year, so it must be mentioned even though it’s unlikely to be executed upon. Even without anymore hikes, the yield curve will likely invert, and the economy should weaken further.

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