Remain Calm and Move Quietly Towards the Exit

From the September 15, 2015 HRA Journal: Issue 238-239 

I did a lot of agonizing about this month’s main editorial and, truth to tell, I’m still partially on the fence about the market’s major direction.  I think the odds of a drop of bear market (20% plus) proportions is very high right now, I’m just not sure how fast it will happen.

If the US Fed really fumbles at the next meeting for instance hiking rates without clearly enunciating it won’t do it again for quite a while we could see the next down leg in days.   If the Fed stands pat and does a great job of calming nerves that may put off further drops but I think the relief will be fairly temporary.  I see no reason to think we won’t see another quarter of lower profits and perhaps lower revenues as we move through Q3 reporting next month.  Barring some sort of valuation voodoo I don’t think the market can hold up to three of those in a row.   

It would be unusual to see a recession with the fiscal and monetary backdrop we have.  Even if the market drops 20% plus the economy may stumble along well enough to make it a short drop.  I certainly wouldn’t say I look forward to that sort of drop but I’m not panicking about either.  I have felt for some time that the markets and the precious metals sector in particular were in desperate need of a reset.  A short and sharp dive in the main indices may provide that reset and deliver a bottom traders can believe in. Stay tuned.

***

After months of sideways movement and low volatility US markets finally made a break for it and it was to the downside.  There has been plenty of angst and hyperbole since the S&P broke lower.  Every second article about the market now contains the word “”crash”.  Ironic since so many were—and still are—bullish about the market.   The word is being bandied about most by those that thought developments in the rest of the world portend nothing for US markets. 

As you know, I have expected bad news from US markets for a while now.  The repeated inability to move higher combined with narrowing breadth had me fearing there was worse to come.

The break in trend is abundantly clear in the one year chart above.  The move accelerated once the S&P dropped below the long term trend line that has been supportive since 2009. 

The chart above shows the 50 and 200 day moving average. The more ominous trend break occurred a day or two into the drop when the average cut below the straight trend line connecting correction bottoms for the past six years.  That trend line—unlike the 200 day moving average—had not been violated prior to this drop.  We can argue ad nauseam about how much that means but there is no denying we’ve seen a major shift.  In any case, we’ll know soon enough.

Take another look at the chart on the first page.  I made the timeframe long enough to include last October’s dip, which didn’t go quite far enough to even be called a technical (10%) correction.  It’s still early days in the current situation but you can see how different the current move looks compared to last October’s and all other dips before going back to at least 2011.

Last October and other v-shaped corrections train traders to “buy the dip”.  If this is just another bull market setback it makes eminent sense to do just that.  That is, in fact, the central question now.  Is this just another bull market correction that we should jump on and go long or is it something more ominous? 

It could be we’re seeing a repeat of the “Euro” and “Washington Closure” markets of 2010 and 2011. Those were scary but, in the end, just bigger than normal corrections.

I’d like to say this move feels the same to me. That would make me near-term bullish but I’m afraid the odds are we’re looking at the start of a 20%+ down move (a “bear market” technically speaking) and a “crash” shouldn’t be ruled out.

Before I go further let’s deal with that scary word “crash” I brought up earlier.  It’s been very overused lately.  What we have seen so far is by no means that.  Trust me, I’ve been through a few crashes and they are far uglier than what we have witnessed so far.  This isn’t a crash. Yet.

Most of the market observers screaming crash are trying to look clever by telling traders not to panic.  You can almost hear them using their “serious news announcer” voice to caution that the worst thing to do during a crash is panic and sell.

Don’t get me wrong.  I don’t disagree with that advice as long as you get the timing right.  That’s always the tricky part.  It’s totally acceptable to panic in the market—as long as you’re one of the first to do it, not the last.

Sentiment surveys are being widely used to back up bullish “don’t panic” calls in the past few days. Sentiment is definitely important.  It’s often the main determinant of a change in trend.  All surveys have their problems from sample bias to question selection but we work with what we have.

The chart above is the Investors Intelligence bull-bear survey that is being heavily quoted.  Lots of commentators are pointing out how silly it was to be selling when the bull minus bear percentage hit zero in 2010 and 2011.  I agree but it’s important to note that its not just the spread that matters but the absolute percentage of bulls and bears.  Viewed in that context the current readings are not that extreme.

If you look back to 2007-2009 you’ll note that selling when the bull-bear spread was zero (this happened several times) was still a smart move— as long as you were early and had the intestinal fortitude to get back in near the bottom. 

The bottom didn’t come when the spread turned negative.  It came when the absolute percentage of bears topped out at almost twice its current level. Indeed, that extreme bear reading was one of the reasons I called a bottom in 2009.   Yes, advisors are suddenly more bearish but not bottom of a bear market bearish.

Reported Date

Bullish

Neutral

Bearish

September 10:

34.65%

30.34%

35.01%

September 3:

32.38%

35.94%

31.67%

August 27:

32.50%

29.23%

38.27%

August 20:

26.82%

39.85%

33.33%

August 13:

30.45%

33.40%

36.15%

August 6:

24.32%

44.03%

31.66%

July 30:

21.11%

38.19%

40.70%

July 23:

32.54%

41.87%

25.60%

July 16:

30.81%

45.95%

23.24%

July 9:

27.91%

42.92%

29.18%

July 2:

22.61%

42.30%

35.09%

June 25:

35.56%

42.78%

21.67%

June 18:

25.41%

40.29%

34.30%

June 11:

20.04%

47.38%

32.58%

June 4:

27.34%

48.03%

24.63%

The table above shows the weekly results of a similar survey from the American Association of Individual Investors.  I find this one particularly interesting.  The numbers bounce around but the main change is that both bullishness and bearishness have increased while the neutral or undecided percentage has dropped.

It looks like battle lines are being drawn in a fight that isn’t over yet.   It’s also interesting to note that bullishness has increased since the heavy drops of late August.  That tells me that traders are buying the dip which helps explain recent gains.

That’s all good but it doesn’t mean we’re out of the woods.  There was plenty of excitement when markets staged big one day rallies in the past three weeks.  Unfortunately, sharp one day rallies like that are far more common in bear markets than bull markets.  I think those rallies are another negative sign.

Staying on the subject of sentiment for a moment it’s instructive to look at the Gallup Economic Confidence survey below.  The steep dip we’ve just seen is surely due to market turmoil but that isn’t the reason I included it.  The chart shows that confidence in current conditions and even more dramatically, future outlook, topped out near the start of this year.  However rosy Wall St may have been Main St wasn’t playing along.

Other market indicators like fund flows bear this out.  Yes, there was a jump in equity fund withdrawals after the August drop but those were a continuation of a pattern already in place. 

The truth is that things have been deteriorating for US corporations for a while now, it just hasn’t shown up in the index until now.  The absolute level of S&P earnings topped out early this year.  The US trade weighted US Dollar continues to climb doing further damage to revues and unit sales.  Yes, the energy sector is a big part of the profit decline, but not the only part.

In addition, fund flows were not that strong even before the August drop.  The biggest buyer in the market by far has been corporations buying back their own stock, usually with borrowed money. Some of the support buying in the past three weeks came from the same source.  I think that would be scaled back if the markets really dropped.  Management doesn’t want to look like it’s catching a falling knife and it’s a lot easier to sell buybacks to shareholders when you can say you bought the stock at cheaper rather than higher prices.

When you see a rapid drop like we did in late August then a bounce the story rarely ends there.  Historically, the market will retest the low most of the time.  I think that happens again, probably this month. 

We’ll have to see if the market passes the test next time the S&P gets to the 1860 level.  That could be the worst of it but based on what I’m seeing I think that test may fail.  At that point the odds of a precipitous decline increase dramatically.

What drives things going forward?  The same things that have up to now; China and EM news and the Fed.

China’s economic readings continue to deteriorate in the case of both internal consumption and investment and international trade.  US commentators focused on the widening trade surplus but it was weakness in imports and exports both that were the real story.  Growth is certainly below the 7% official target, and it’s been getting worse by the month.  Unless Beijing can figure out how to reverse this China and the many EM economies dependent on it will be an increasing drag on the world economy.  Beijing is trying to assure traders that it has things under control but I also expect Shanghai to see new lows.  That won’t help sentiment elsewhere.

That leaves us with (wait for it!) the Fed as a short term market mover—maybe.  Until quite recently I expected to see the Fed raise rates this month.  It missed its best chance late last year and many Fed governors clearly feel the need to establish credibility.  That’s not the best reason to do it but there you are.

The bond market is currently pricing in a 28% chance of the Fed raising rates 25 bps at the next meeting.  That’s lower than my own (reduced) probability.  I think a rate hike is roughly a 50:50 coin flip at this point but that estimate would drop if the markets fall much more before the meeting.  I’d like to see it happen for selfish reasons enunciated in recent issues but I can see why the Fed would hesitate.

The chart below shows a trace of central bank foreign reserve holdings for the past two years.  The cumulative amount of foreign reserves has dropped $750 billion and even that doesn’t tell the whole story. 

A host of EM countries, notably China, are in the midst of severe bear markets for their home currencies and/or facing large scale currency outflows.  Unlike the days of the Asian Crisis in 1997 most EM central banks have adequate foreign exchange reserves, at least for now. 

EM central banks can afford to undertake market operations to defend their home currencies and most are doing just that.  They are buying home currency and selling foreign (mainly US) currency and bonds.  This hasn’t created any major dislocations but it is reducing liquidity in the international financial system.  Flows have accelerated in the past few weeks so the foreign reserve losses are probably closer to a trillion now.

If this was just about trade most EM central banks would be happy to see their currencies drop though they would swear otherwise.  These drops are giving at least transitory trade advantage but they also risk higher inflation and, more ominously, raise local currency cost of debt service.

Many EM countries—Brazil is a notable example—have high levels of $US denominated debt owed by private borrowers. Remember Long Term Capital?  It was undone by a crashing Russian ruble. 

I’m not saying we’ll get a repeat but central bankers elsewhere are worried enough to demand the US hold the line on rates.  Fed governors aren’t supposed to care about that but have to take the onshore effects into account. 

A recent report by Goldman Sachs estimated the combination of falling reserves and widening credit spreads amounted to tightening of US financing conditions equal to three 25 bps Fed rate hikes.  That sounds overdone to me but I agree that recent happenings in the market are effectively the same as an increase in the Fed rate.  The market has done the Fed’s job for it (again).

My sense is that equity traders think they have convinced the Fed to hold off.  If that is true I don’t see how we get much joy from a stand pat announcement from the Fed.  That’s particularly true since it means traders would just continue to obsess about the timing of the increase.

If the Fed governors agree with my reasoning they would be tempted to pull the trigger.  If the market isn’t going to respond positively to keeping rates at zero why not get the increase over with?

If the Fed raises rates it will be critically important how they word the announcement and how Yellen handles the subsequent press conference.  If the Fed can sell “one and done” then the reactions would not be too negative.  If traders decide the Hawks have taken over the committee and there is a series of hikes coming, look out below.

For the record, while I don’t think a 20%+ drop is a certainty I’m concerned enough to be seriously looking at instruments like Index Put Options.   I don’t generally trade stuff like this and would not suggest anyone else does without talking to their advisor first.   Both options and index ETF’s present real potential for 100% losses if the market doesn’t go the way you bet.  Buyer beware.

While I think the potential for a 20%+ drop in US markets is now quite real I also think if it happens it could be over fairly quickly.   At this point I don’t see the odds of an outright US recession being that high.  I can’t disagree with the bulls that a recession would be unusual with the current monetary/fiscal backdrop.  That doesn’t mean impossible, just unlikely. 

It’s also wise to remember something bulls tend to forget.  Stock markets are themselves one of the most leading indicators.  A big enough drop can help create a recession but it would have to be larger and more long lived than I expect this one to be.  The danger in a real market breakdown would be HFT and Quant robots running amok and selling everything in sight.  A couple of 100 point down days for the S&P would be a real possibility before the software was back on the leash.

Does that mean gold or commodities are a place to hide?  Perhaps not immediately. If there is a real panic there is potential for margin related selling of gold along with everything else.  I do think gold would be one of the first things to bounce though and the short bear market is part of my scenario that envisages a long term bottom in the gold price forming soon.  

A spike down might convince traders the bottom was finally in.  While there are plenty of articles from people who know nothing about the gold market calling for much lower lows those with actual track records are beginning to suspect we don’t get through and maybe not even to $1000/oz.

Physical buying has been strong everywhere and the market is still well positioned to bounce.  Also worth noting is the chart above that shows the moderately negative correlation between gold and equities.  It’s using a much longer correlation period than I would in practice.  Correlation bounces around a lot. I would expect it to be weakly positive (moving with the market) in a large drop but to quickly turn negative (move up against falling equities) as fears increased.  As I have noted many times gold and gold and silver miners have been good hedges in the past that bottomed well before equities in general.

On the base metals side there have been recent gains for copper and we could see some of that repeated for other metals coming out of an equity market drop.  Copper has benefited from supply cutbacks.  Copper miners are usually quick to do that.  Hopefully some others get the hint.  Frankly, the same goes for gold and silver miners.  Announcing mine closures is no one’s idea of fun but it is the sort of thing that gets traders believing a bottom is in.  Base metal miners need clarity from China but for precious metals and copper the pain may soon be over.

Be careful out there!  The ride could be bumpy for a while.

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