Submitted by Lance Roberts via STA Wealth Management, [20]
In last week's update, I discussed the short-term oversold condition that existed at that time. To wit: [21]
"As you can see, the markets did retest the late August lows, and when combined with the very oversold conditions, led to a frantic "short covering" rally back to previous resistance. It is worth noting that the recent market action is very similar to that of the August decline and initial rebound as well.
Of course, the question that must be answered is whether we have seen the end of the current correction or is this just another "reflexive rally" that will fail?"
The chart below is updated through yesterday's close.
[22]
Currently, the bulls have clearly been in charge of the market. The question is for "how long?"
While last week's FOMC minutes gave the "bulls" some confidence that the Federal Reserve is not removing its accommodative policy, it was the massive amount of short-interest (people betting on markets to fall) that provided the fuel.
[23]
The chart above, from ZeroHedge [24], shows the massive jump in short-interest that has to be covered as stock prices rise. When players are "short the market," bullish reversals in prices force traders to close out their positions by "buying" into the market. This fuels additional buying, which pushes prices higher, which forces more players to close out their short positions. This cycle continues until the "fuel" is exhausted. This is why market rebounds tend to be extremely sharp and fast, but also fade just as quickly.
For a visualization think about the "Whoosh Bottle" where an air/gas mixture is fairly inert until ignited by a catalyst. (Vine by @scienceporn)
That mixture of oversold market conditions, combined with a sharp rise in "short interest" in the market, was the perfect accelerant waiting on a match. That match was the Fed failing to hike rates and a lack of China in the headlines.
However, there is a big difference between a fundamentally based "bull market" advance and a short-covering rally in a "bear market" cycle. While it is too early to say that we are indeed in a bear market, there are many indications such is indeed the case as I discussed yesterday in "4 Warnings." [25]
- Profit margins have had a 60bp decline.
- Margin debt has fallen below its moving average.
- Valuations have started to contract.
- Economic measures have fallen sharply.
Add to those fundamental arguments the technical deterioration of momentum and relative strength in the market and a more worrisome picture emerges.
[26]
Importantly, despite many of the mainstream calls for a continued bull market, it is worth noting that historically the negative alignment of both the fundamental warnings and technical indicators have only occurred at the onset of more protracted bear market declines.
Could this time be different? It's possible, particularly if the Federal Reserve once again intervenes with more liquidity driven monetary policy. However, such action by the Federal Reserve seems unlikely as they are focused on "tightening" monetary policy by hiking interest rates, rather than "loosening" it with additional liquidity. Of course, another sharp decline in the market that erodes consumer confidence will likely quickly change their stance.
Is This 2000, 2007 or 2011?
One of the primary arguments by the more "bullish" media is that the current setup is much like that of 2011 following the "debt ceiling" debate and global economic slowdown caused by the Tsunami in Japan.
While there are certainly some similarities, such as the weakness being spread from China and a market selloff, there are some marked differences.
From a fundamental standpoint the Federal Reserve, along with the ECB, were actively engaged in pushing support for the financial markets globally. This is not the case today, as stated above.
Furthermore, the economy was "saved" in Q3 and Q4 of 2011 by the warmest winter in 65 years that allowed for continued manufacturing and production during a period when inclement weather is generally a concern. This also coincided with the "reboot" in Japan which allowed for "pent up" demand to be filled. As we once again face an extremely cold winter period, as we saw in the last two, the outcome fundamentally is far different.
From a technical backdrop, there is a striking difference as well. In 2011, asset prices plunged on fears of a "debt default" coupled with the lack of liquidity following the end of QE 2. However, price momentum and the relative strength of the underlying market internals remained bullishly biased.
[27]
Currently, the technical deterioration is more aligned with the previous bear market cycle as "sell signals" have been registered for only the third time since the turn of the century. With only one "sell signal" not registered, the moving average crossover, there is a minor "hope" for the bulls at this juncture. However, given the steepness of the decent it is likely that signal will be registered in the weeks ahead if the "bulls" are unable to gain solid footing and push markets to new highs fairly quickly.
No matter how you want to view the market, it is hard to make the case that this is simply just a correction within an ongoing bull market cycle. As I quoted in yesterday's post (Edward Harrison [25]):
"We are now in the seventh year of a cyclical recovery and bull market. Shares have tripled in that time frame. I would say this means we are much closer to the end of the business cycle than the beginning.
To me, the pre-conditions for this profits recession speak to downside risk, both for risk assets and for the real economy. None of the data speaks to recession in the real economy right now. We are seeing a slowing of job growth and likely of trend economic growth as well. But with a profits recession hitting, the potential for further downside is high."
That view, combined with the fundamental and technical backdrop that is more aligned with historical bear market cycles, suggests that excessive risk taking currently is ill-advised. If the backdrop changes to a conducive environment, then that view will change accordingly. For now, it remains prudent to use rallies to reduce risk. Remember, it is always easier to get back into the market once the path higher is clear. Conversely, it is harder, and a bit pointless, to keep using rallies simply to make up previous losses. Getting "back to even" is simply not a viable long-term investment strategy.
