Stocks Crash Then Rally
The wild trading action continued on Friday as stocks whipsawed back and forth. The tweet below gives a quick summary of the action in the Dow. It was quite an unusual day for stocks. At the bottom, this was the worst week since October 2008. However, since the market rebounded it was only the worst week since January 2016. Corrections are always violent, but this one has been more so than usual. Stocks closed up 1.49% on Friday, but down 5.2% for the week. The CNN fear and greed index is at 10 out of 100 which is extreme fear.
Technicals Show Stocks Bounced Off The 200 Day Moving Average
I’m not one to follow the stock market’s technical action, but the past few weeks have been very technically driven. When stocks ignore the fundamentals, the technicals are all traders have left, so they begin to matter more. The rally in January pushed the market in a vertical direction which was unsustainable. The economic backdrop and earnings are good, but the speed of the rally and the sentiment were too bullish. I looked at the RSI and the moving averages, to help understand when the rally would end. This week stocks crashed about 12% at the trough. The extreme vacillations were clearly based on technical action because the fundamentals can’t change that quickly. As you can see from the chart below, the S&P 500 tagged the 200 day moving average before bouncing higher; 2,532 is an important level to watch. The trough should act as support next week if stocks fall.
The chart below is a great contrarian indicator which signals the stock market decline is almost over. Clearly, I was a few days early in my bullish call. However, I remain bullish as the net position in CoT VIX futures went from short 59,000 contracts to long 86,000 contracts. This correction in stocks is very similar to the one in August 2015. The original fear in stocks started with the VIX increase, so this information is vital.
Is The 10 Year Yield Causing The Selloff?
The 10 year bond yield was up about 3 basis points to 2.85%. While that is supposed to be bearish for stocks, yields acted in tandem with stocks on Friday. They fell to 2.79% at the bottom and rallied at the end of the day when stocks rallied. This is what makes the narrative fall apart. If higher yields cause stocks to fall, why are stocks correlated to them? The logic doesn’t hold, but if higher yields actually hurt stocks then expect them to fall on Monday with this latest increase in yields. In fact, stocks will fall into a bear market if they are truly inversely related to bond yields because the 10 year is going to 3% in my opinion.
I maintain the notion that the stock market will act in tandem with yields until the 10 year reaches 3.5%. In a similar vein, those who say stocks are falling because of heightened inflation expectations don’t make much sense because the 10 year breakeven rate fell 5 basis points from last Friday to this Thursday. If you believe inflation will cause a crash, there’s room to hedge the inflation risk because it’s not popular. In this case, I agree with the market because I think inflation has more room to run before it’s an issue.
Finally, the yield curve steepened as the difference between the 10 year bond and the 2 year bond increased to 78 basis points. It seems like every trade saw a reversal including the yield curve even though you would think a bear market could cause economic weakness. This correction in the curve doesn’t change my perspective because I expected it to steepen this year at times, just like I called for a 10%-15% correction in stocks. Now, I think stocks have room to run until the cycle ends in 1-3 years. I think the yield curve will invert in the next 5-17 months.
Historic Reversal
There is much less risk in the stock market because valuations got better and the impending doom that was the short volatility trade has been realized. If the risk is taken out of the market, then it’s a bullish sign even though it feels terrible. As you can see from the chart below, the 2 week change in the S&P 500’s 14 day RSI was the most negative ever. The stock market went from the quietest ever to having the biggest momentum shift ever. The market was like a slinky which was pressed down and then expanded.
Fed Fund Futures Change Modestly
The Fed fund futures are still projecting a rate hike in March. The chance of a 25 basis point increase at the March 21st meeting fell from 76.1% to 71.9% on Friday. As long as the percentage stays above 70%, I think there will be a hike. The reason the futures didn’t start expecting fewer hikes is because the Fed didn’t change its policy because of the correction. There are two interpretations of this reaction. One is Powell is a new type of Fed chair who allows the free market to work and doesn’t intrude during a sell off to calm the markets. This has always been a plausible assessment of how Powell would act as chair. The 2nd possibility, which I think is more likely, is that the Fed didn’t say anything because it thought the rally in the past few months was unsustainable. The Fed was probably happy the euphoria left the market.
Dollar Rises & Oil Falls
The dollar index continued its positivity as it was up 9 cents to $90.32. Oil crashed on Friday. WTI fell 3.2% to $59.20. It fell 9.6% this week which was the worst performance in 2 years. The rig count increased by 26 to 791 which is the highest amount since April 2015. The head of the Russian energy firm Gazprom said the producers could change their commitments under the OPEC deal next quarter. He said he wants output to be raised because the market is balanced. This is exactly what I said would happen. Falling oil prices hurts the energy sector. It hurts America more than usual because America is now a large producer of the commodity.
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