Bad Hair Days For Stocks: What's Next?

By Pater Tenebrarum at Acting Man Blog

About one month ago we wrote two updates on market sentiment in close succession, one of which included a money supply update as well (see: “Boundless Optimism in the Stock Market” and “Market Sentiment and Money Supply Update” for details). On this occasion we pointed to an unusual spike in the OEX put/call ratio, commenting:

“[...] if a warning signal is legitimate, it usually has a certain lead time (two to four weeks). It is impossible to tell in advance whether it warns merely of a run-of-the-mill correction or of something worse”

This is still applicable of course, and we can now state that the lead time was indeed approximately four weeks in this case.  Apart from the past few days of trading, the market at first continued to levitate, teflon-like, unimpressed by any and all possibly worrisome data points. Wednesday's GDP data release, while superficially strong, owed 1.7% of its 4% annualized growth rate to inventory building, so it was probably widely discounted as another so-so report. The release of the Chicago PMI , which tumbled to a one year low in its biggest monthly drop since October 2008, immediately contradicted the happy GDP data anyway. Initial jobless claims rose fairly sharply from one small number to another small number, and are only worth mentioning because the stock market tends to be inversely correlated with them in the the long term.

As so often, it is difficult to identify what actually triggered the sudden selling squall, because lots of things appeared to be happening at once, or at least in very close succession.

Among these is the attempt to pressure Russia into abandoning the Eastern Ukrainian rebels by means of sanctions, so that Kiev can slaughter them more leisurely, and above all, more cheaply. Unfortunately, and predictably, the sanctions toll is already hitting Europe, especially Germany – see this graphic we recently posted. Things keep getting worse, as listed companies are beginning to post earnings disappointments they blame on the sanctions.

The problem is not only that there is already a highly visible economic toll, but in spite of the fact that Russia's economy is under a great deal of pressure as well, Putin remains equally predictably completely intransigent and is now threatening to use the economic levers Russia has at its disposal. According to press reports, he intends to use WTO rules to push these measures through (such as altering the prices on long term gas contracts).

As we have previously remarked in this context, sanctions are just bad for business. They never harm their real targets, namely the political ruling elite of the targeted  country. Quite on the contrary, Putin has experienced a big surge in domestic popularity.

Chart-1-Bad Hair DayA bad day for stocks – prior to the decline we received a number of warning signs, such as the deterioration in relative performance of the Russell 2000 Index, as well as numerous other divergences between the indexes themselves and various oscillators. DJIA and SPX (not shown) have both fallen out of rising wedge formations – click to enlarge.

When we wrote about the OEX put-call ratio spike recently, we neglected to point out that there was also a big spike in SKEW around the same time. Skew essentially is a kind of “institutional tail risk perceptions” indicator, as it measures how pricey far out of the money SPX options are. It is now retreating, but remains at a historically high level. Values above 140 are really absolute record high territory.

Chart-2-SKEWSKEW also spiked ahead of the recent decline – click to enlarge.

In our last update of Rydex ratio data, we pointed out that a bull/bear asset ratio of about 18 seemed to be the “upper limit” for net bullish exposure in the Rydex fund family. In fact however, it has risen even further thereafter, to a recent level of 18.52, a new record high.

This was the fourth time this year that the ratio has moved to a level beyond its manic peak of early 2000. This and many other survey and positioning data continue to contradict the widespread claim that this bull market is “hated”. The last time traders really hated the market was back in 2009.

We find this persistent surfeit of bullish sentiment quite fascinating, mainly because nothing like it has ever been seen before.

Chart-3-Rydex chartAn update of your Rydex chart – the ratio of bull to bear assets is at a new record high of 18.52 – click to enlarge.

 This time we also want to show a long term chart of the mutual fund cash-to-assets ratio, beginning in 1955. It illustrates nicely what mutual fund managers thought of the market shortly before it embarked on a secular bull market. It is quite a contrast to today's situation, where not even a 58% decline between 2007 to 2009 was able to shake their conviction much.

European Troubles

We noted above that a great many things seemed to be happening at once, and one of those was that the problems of Espirito Santo Bank (BES) in Portugal keep worsening. The Bank reported an unexpectedly large loss, shortly after postponing its shareholder meeting on the grounds that “new facts”  had mysteriously turned up.

“Banco Espirito Santo SA’s stock plunged by the most on record and the bonds slumped after it was ordered to raise capital following a 3.6 billion-euro ($4.8 billion) first-half net loss.

The Bank of Portugal required the lender to raise the money after it set aside 4.25 billion euros in the first half, mostly to cover souring loans to other members of the Espirito Santo Group. That cut Banco Espirito Santo’s common equity Tier 1 ratio to 5 percent, less than the 7 percent regulatory minimum, according to a statement yesterday. The central bank is also probing the lender’s former managers and suspended executives in charge of audit, compliance and risk management.

“It’s a very substantial capital increase in a difficult environment,” said Benjie Creelan-Sandford, an analyst at Macquarie Bank Ltd. in London who estimates the lender may need to raise about about 3 billion euros. “There is a question whether there are investors given the size of the capital increase needed or if they will need to resort to state aid. It is there as a last resort.”

(emphasis added)

“State aid” it will probably be, but the problem is of course that Portugal's government itself only recently emerged from technical bankruptcy. Goldman Sachs together with a large US based hedge fund recently invested a large amount in BES' equity and they have already experienced a stock split the old-fashioned way, as the stock plunged by over 40% on Thursday alone.

Chart-5-BESThe stock of BES exhibits a high frequency of crashes recently. GS and others have bought into this falling knife and are already down half – click to enlarge.

 As a result of these developments, Portugal's overall market continues to be Europe's worst-looking at the moment. It has been plunging ever since it violated a lateral support level we have pointed out in a previous article on the growing troubles of BES. Portugal Telecom isn't going to get its money back it seems, and continues to be one of the major financial victims of the scandal. Not surprisingly, its stock remains under great pressure as well.

Chart-6-PSI-20Portugal's entire market keeps falling with some verve – click to enlarge.

 However, it is not just Portugal's market that looks wobbly in Europe. Even the continent's strongest stock market, Germany's DAX, looks a bit frayed around the edges all of a sudden. It has just broken below its 200 day moving average for the first time in ages:


Chart-7-DAXThe DAX also doesn't look too well at the moment – click to enlarge.

 The DAX has strong lateral support around the 9,000 – 9,200 points level. If that area of support breaks, it will likely also enter a bear market. That is however a bridge we will cross when we get there. So far, the downturn in the Euro-Stoxx 50 Index in Europe could still turn out to be a routine correction. However, it has definitely broken its short term uptrend line:

Chart-8-Euro_stoxx_50Euro Stoxx 50 – down, but perhaps not out yet – click to enlarge.


At the very least, a correction of some significance seems to have begun. This was already foreshadowed by the recent weakness in high yield debt and the associated increase in credit spreads, as well as the ever larger divergence between big and small cap performance. If the markets are in for something worse than a routine correction, then we should per experience see a move down by about 10%, followed by a rally that fails at a lower high. Stay tuned.



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