BK: After a Rough Third Quarter, Will Atlas Shrug? – $SPX
After a Rough Third Quarter, Will Atlas Shrug?
The unwavering belief that the Chinese economy was a perpetual growth engine became a pillar of the bull market. The engine stalled this summer. Actually, the Chinese economy had been sputtering for a while, but it took the devaluation of the currency to change investor perception. The second pillar of the bull market is the so-called ‘Fed Put” and its structural integrity is about to be tested.
For the better part of 2015, the US stock market traded in a historically narrow range as investors disputed the signal of falling commodity prices. When the bulls charged they declared that falling commodity prices were a result of oversupply, but when the bears roared back it was about falling demand from a weak Chinese economy.
On August 11, the Chinese government devalued its currency; four days later the S&P 500 began to crumble, the markets entered a precipitous decline that shaved over $600 billion in market capitalization from US corporations and culminated on August 24 when the Dow Jones Industrial Average fell over 1,000 points in the first few minutes of trading. The battle was over. The bears had won.
Now a bigger battle is about to take place.
Since the Great Financial Crisis, central bankers have acted like Atlas, holding up the financial markets on their shoulders with the help of quantitative easing. Investors have not only benefited from unprecedented monetary policies but also unprecedented coordination of policies. However, the US Federal Reserve (the biggest, baddest and strongest central bank) has declared its intention to take break from holding up the world.
To be fair, the Federal Reserve has been doing most of the work. While the Bank of Japan has shouldered some of the burden, it took the European Central Bank a long time to begin its monetary easing. Now that ‘other’ central banks are printing money, the FED has said it needs a break – but its timing could not be worse.
By almost all measures the global economy is slowing. The slowdown in the global economy has been most notable in the emerging markets dependent on commodity exports. Brazil is a prime example of a high growth economy that has been decimated by low oil and iron ore prices. Adding to Brazil’s misery is a political crisis that is part and parcel to an economic decline. Now the emerging market economic decline is beginning to impact the United States.
The US jobs report for both September and August showed that job creation is decelerating. But even before the disappointing jobs report, other forward looking economic indicators were exhibiting signs of weakness. On October 1, the ISM Manufacturing Index (a closely watched gauge of economic activity) printed a 50.2 reading, just shy of economic contraction. Any reading of the ISM Index that is below 50 is considered to indicate a slowdown in the economy and an early warning sign of recession.
The signs of a slowdown and possible recession are clear, yet the FED is fixated on raising interest rates.
Will Atlas Shrug?
If the FED is truly data dependent, then it is hard to see how it could justify raising interest rates at this point in the economic cycle. In fact, many market participants are beginning to openly talk about QE4. Investors have been conditioned to expect the FED to hold up the world anytime the data turns negative. But the FED has painted itself into a corner – it has committed to “lift-off’ despite the weak data – herein lay the battle.
Obedient investors will buy stocks expecting the FED to change course and abandon the planned rate increase. If the FED refuses to budge, investors will throw another tantrum causing stocks to fall. The belief is that falling stocks will force the FED to continue to support asset prices, but the danger is that the FED does not comply.
The push and pull between markets and policy makers is the battle that will be fought during the fourth quarter. The good news for traders is that volatility is here to stay; the bad news for investors is that the outcome of this battle is far from clear. The FED wants out of the asset supporting game, but if it shrugs the major pillar of the bull market will crumble.
How Do You Trade the Battle?
If my view of an epic battle between markets and policy makers proves to be correct, then the massive rally in the S&P 500 after a poor employment report begins to make more sense. As if on cue, investors bought stocks in anticipation of the FED backing off its lift-off pledge. Interestingly, even yours truly was caught up in the pre-programmed reaction when I posted “Here Comes Permanent QE”.
Viewed in through the lens of a battle, it makes sense to tentatively label any rally as a correction within in a bear market. I have labeled the following chart of the S&P 500 with the perceived corrective pattern.
It appears that the S&P 500 is in the process of an A–B–C corrective pattern. Wave A was the relief rally from the August 24th capitulation bottom. Wave B was a false resumption of the downtrend as it became clear the US economy was slowing. It appears that the S&P 500 is now just beginning wave C that should be the final leg up in this corrective pattern. A good estimate for how far wave C will travel is to use the magnitude of wave A as a guide. Typically, wave C travels an equal amount of points as wave A.
Using the equal points rule of thumb, puts the wave C target at 2050. This target takes on more significance because it also appears that it will correspond with the 200 day moving average and the long term uptrend line that was broken in August.
Even more interesting is the timing of this perceived corrective rally. Not only is it typical for wave C to travel as many points as wave A, but it is also typical that wave C last as long as A in time. Using this metric, the target end date for any corrective rally is the end of October… the same time as the next FED meeting. (Cue ominous music)
I had been short of the S&P 500 going into the US jobs report. I went from zero to hero in one trading session. Thankfully my short entry point allowed me to salvage the trade, but I have still “lost” unbooked profits – I consider this loss as part of my research budget. Throughout my career I have read thousands of research reports, but none have ever told me as much (or been more useful) as lost profits.
The trading plan is to be long of the S&P 500 in anticipation of a rally predicated on the FED backing away from its lift-off pledge. It’s likely that I will wait for a sell-off to enter any long position so that I can improve my risk reward.