Another Bad Hair Day
At the beginning of the week, it looked like a rebound in stocks might get underway – and why not? After all, the market is a bit oversold by now. In fact, a number of indexes are oversold quite a bit. But then came Wednesday, and turned into another bad hair day – a really bad one.
A surprised market participant joins the stock market in having a bad hair day.
Photo via pinterest.com
Needless to say, this remains highly unusual market behavior for early January. And this week is an options expiration week to boot, which reminds us that the warning shot in August also happened during an expiration week (plus the Monday following the expiration).
Probably because it is early January and this market behavior is so unusual, there is no real sense of fear yet. There are certainly many scary headlines and bears are becoming increasingly more vocal. For instance, famous bear Albert Edwards of Soc-Gen has just decided he needs to lower his target…quite a bit. In a noteworthy similarity to us, his timing is occasionally off by a few years, but he also has a disconcerting habit of being vindicated at some point down the road.
Said “some point” may be in the process of arriving. On the other hand, there are also still many true believers going on about imminent v-shaped recoveries. In fact, it feels like there are still way too many of those. We note in the meantime that the downside leaders continue to lead to the downside – here are three of them:
The Dow Jones Transportation Average, the Russell 2000 and the NYSE Composite Index have all broken below their August 2015 mini-panic lows – with the breakdown of the former two looking rather decisive by now. Transports and small caps were two of the relative strength leaders of the bull market, while the NYA reflects the broader market. That all of these indexes are now leading the downturn should give one pause – click to enlarge.
Oversold conditions in term of momentum-type indicators by now close to or at extremes across the board. A bounce should therefore probably soon begin (i.e., within a few days). As we have pointed out on Tuesday, the quality of the next market rebound should be quite informative. It is hard to say though from whence it will begin, as oversold conditions can always become worse in the short term.
The more popular averages and indexes which are more heavily weighted toward reflecting big cap performance are closing in on their August 2015 lows, but haven’t broken below them yet:
Dow Jones Industrial Average, S&P 500 and Nasdaq Composite – weak, but still above their warning shot lows of last August – click to enlarge.
This creates a potentially positive short term divergence, but it obviously wouldn’t take much to erase it.
Still too Much Complacency?
Assorted fear indicators such as put-call ratios and the VIX are by now elevated, but curiously enough, they have failed to produce extreme readings, especially compared to the August sell-off .
Unfortunately there is no hard-and-fast rule as to how to interpret this. It could be that it represents a positive divergence as well. However, it could also be a sign that there is still far too much complacency.
Equity put-call volume ratio: relatively high, but not really expressing abject fear yet. This is a bit surprising, considering the extent and speed of the sell-off – click to enlarge.
The VIX, a.k.a. the “fear index”, which measures the volatility premiums of SPX options. This is has been a surprisingly lame advance so far – click to enlarge.
The ISE call-put ratio seemingly indicates that traders are fast asleep. Or rather, it shows that the small bounce on Monday and Tuesday had them convinced very quickly that the market was about to turn around:
ISE call-put ratio (in this case, high readings are considered contrarian bearish and vice versa). Traders seem thoroughly unworried based on the last two readings. They didn’t regain their conviction this fast after the August lows – click to enlarge.
Finally, as an aside to all this, OEX put-call ratios are widely seen as a confirming rather than a contrarian indicators, as OEX options are considered the playground of “smart money” players. Both the OEX volume put-call ratio and the OEX put-call open interest ratio will tend to spike ahead of major sell-offs, but usually the actual downturn in prices lags these spikes to some extent (the duration of the lag is variable, and occasionally there are false alarms). Not so this time around:
The OEX put-call open interest ratio has spiked to a record high – exactly one day before the sell-off began. To be fair, it has been trending sharply higher for several weeks already. Still, it is unusual to see no lag at all between the ratio reaching a peak reading and a subsequent market sell-off – click to enlarge.
Evidently, not everybody was surprised by the selling squall, but our impression from reading mainstream financial media reports is that the number of people that have been surprised exceeds that of the unsurprised ones by a sizable margin.
Perhaps this is because the plethora of warning signs that has accumulated throughout 2015 hasn’t meant much so far. However, it now apoears as though these warning signs were indeed meaningful.
The Federal Backpedaling Brigade Swarms Out
It is also interesting that after some tough talk was delivered by Fed officials on the first trading day of the year, more recently a few of the Fed’s well-known doves have been wheeled out to engage in some verbal backpedaling on the central bank’s widely known rate hike plans.
First up to bat was Chicago Fed president Charles Evans, who declared that in his opinion, the economy could not possibly withstand more than two rate hikes this year:
“Chicago Federal Reserve President Charles Evans said on Thursday his view of the U.S. interest rate path in 2016 was consistent with two hikes, and cautioned that monetary policy must take into account the potential for lower economic growth in the long term.
“I think appropriate policy is consistent with some of the most accommodative dots on the chart,” Evans said, referring to the range of economic projections Fed policymakers have given for the Fed’s benchmark interest rate by the end of 2016. Their median estimate is for four quarter-point rate hikes this year, but Evans is among the Fed’s most cautious members and sees risks tilted to the downside.”
Mind, that was on January 7. If he were interviewed again today, he might well say that one should perhaps wait with implementing any further rate hikes until kingdom come, or some other version of eternity.
Charles Evans threatening his off-camera conversation partner with a pencil.
Photo credit: Andrew Harrer / Bloomberg
Next we heard from Boston Fed president Eric Rosengren, another noted dove, with moral support provided by none other than Larry Summers (the man who has a plan for everything and everyone of us):
“Boston Fed President Eric Rosengren, a voting member of the U.S. central bank’s policy committee this year, said the path of rate increases might be pulled down by a slowing U.S. economy.
The forecast of four hikes “does have downside risks,” Rosengren said in a speech in Boston. He cited “headwinds” stemming from weakness of major U.S. trading partners and only “limited data” to support the Fed’s forecast of a pickup in inflation. “Further tightening will require data continuing to be strong enough that growth will be at or above potential, so that Federal Reserve policy makers can be confident that inflation will reach our 2% target,” Rosengren said.
[…]Earlier on Wednesday, former Treasury Secretary Larry Summers said Fed officials have had a tendency of being too optimistic about the economy for years. “I’d be surprised if the world economy can comfortably withstand four hikes,” Summers said in an interview on Bloomberg Television. He noted that markets “agree with me,” and are only expecting two hikes this year. “I don’t think you invest your credibility in the idea that you are going to have a substantial number of rate increases in the coming year,” he said.”
(emphasis added)
Summers finally said something we actually agree with – which is probably a first. We are referring to the statement that “Fed officials have had a tendency of being too optimistic about the economy for years”.
Our only recommendation for the central bank is to leave rates alone and let the markets decide their level. Anyway, we find this preemptive verbal assault by doves an interesting development. The stock market trend is likely far more important to the Fed’s decision-making process than it usually lets on.
Conclusion
This is certainly an interesting juncture in the markets. Commodities and EM currencies seem extremely oversold, and stocks are at least sort of oversold (enough so that they would normally start to rebound from around current levels). However, the trend in commodities and EM currencies also serves as a warning that downtrends can at times become relentless over short to medium term time frames.
Lately there is a seemingly endless stream of bad news, as global economic growth appears to be quite weak – weaker than most people thought it would be. China’s situation is as always a bit opaque in terms of official data. However, a number of the unofficial estimates, such as e.g. the estimated amount of non-performing loans in China’s banking system are downright terrifying. The speed at which China’s foreign exchange reserves have recently declined is definitely also raising eyebrows, as it indicates more yuan weakness lies ahead.
A recent chart showing China’s NPLs, ranging from the tiny official numbers to the scariest independent estimates – click to enlarge.
We are mentioning this because an oversold market can easily become more oversold when it keeps being inundated with evidence that economic conditions are not what they were thought to be. The odds-on bet is still that some sort of rebound is quite close, but we caution that a great many things have happened lately that “shouldn’t” be happening.
Charts by: StockCharts, SentimenTrader, Bloomberg
