Stock Rally Runs Into A Storm of Uncertainty
The S&P 500 just ended its worst month since May 2012, but considering all the coming storm of uncertainty, it could’ve been worse. The DJIA, SP500 and Russell 2,000 have dropped below 50-day moving average support, as have the consumer discretionary, consumer staples, financials, healthcare, industrial, technology and utilities sectors within the S&P 500. The only indices/sectors still holding their 50-day MAs are NASDAQ, energy and basic materials.
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| Source: Yahoo.com |
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| Source: Yahoo.com |
Euroland stocks, where investors had begun to look for relative performance, are down 3.3% on the Eurostoxx 50 in recording its 2nd worst week in 11 months. EUR also had a bad week USD dropping back below 1.32. Interesting was the noticeable selloff in “less risky” core markets like Germany and France, while smaller markets like Belgium and Austria have managed to stay above their 50-day MAs. Spanish and Italian sovereign bond spreads jumped nearly 20bps, while Portuguese bonds were the hardest hit as Europe’s VIX spiked.
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| Source: Yahoo.com |
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| Source: 4-Traders.com |
Emerging equity markets were already in a funk, as Brazil, India, Malaysia, Mexico and South Korean markets have already seen dead crosses between their 50 and 200-day MAs. Even once red-hot Japan (in USD-denominated EWJ MSCI Japan) has been unable to hold above its 50-day MA after attempting a rebound from a May hedge fund profit taking selloff.
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| Source: Yahoo.com |
What’s Bothering Stock Prices
What’s bothering stock prices? Basically, a significant increase in investor uncertainty, which they usually hate more than bad news, which can be better discounted than uncertainty.
1. The first uncertainty was Fed chairman Ben Bernanke’s signaling of the Fed’s intention to taper back its “unlimited” QE program. The Fed appears heavily leaning toward implementing a tapering soon despite investor doubts about the sustainability of the US recovery, which could be further threatened by another fight over the US debt ceiling and military action in Syria.
2. The second is another looming partisan fight over an extension of the US debt ceiling. There has been much confusion in the past several months relating to the US debt ceiling, and specifically the fact that total debt subject to the limit has been at just $25 million away from the full limit since late May. To avoid disruptions to the Treasury market, Congress will probably need to raise the deadline by mid-October.
3. The third is “imminent” US military intervention in Syria. Secretary of State Kerry’s hard-hitting speech and reports that US action was “imminent” triggered rising crude oil and gold prices, while President Obama’s decision to back off and wait for US Congressional approval to act caught traders wrong-footed. The unrest, meanwhile, has proved a magnet for militant Islamists, including al-Qaeda affiliates and Iranian-backed Hezbollah. Refugee outflows, the threat of weapons proliferation, and widening sectarian rifts have stoked fears that the civil war may engulf the wider region.
Reflecting this upsurge in uncertainty, the VIX has spiked, albeit well below what could be considered “panic” levels. Depending on how disruptive each of these on-the-immediate time horizon factors are, the current consolidation in global equity markets could linger, taking price levels back to intermediate-term support levels (e.g., 200-day moving averages) even if the long-term recovery trend is not broken, or even lower if the more bearish implications of each factor prevail.
However, the looming Congressional fight over the budget ceiling and whether or not the US “punishes” Syria for using chemical weapons are inherently short-term market uncertainties, as is, to a lesser extent, the Fed’s tapering back of QE. Each factor of course has its cassandras warning of “dire consequences”. In the end, however, the outcomes, i.e., a shallow or more serious market correction, will depend on how sustainable the recovery in global balance sheets, economic activity and corporate profits is.
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| Source: StockCharts.com |
Crude Oil and Gold Corollary to Increased Market Volatility
The corollary to the uptick in S&P 500 volatility has been in the crude oil and gold markets. Crude prices (Brent) have rallied about 20% from April, while gold has rallied about 17% from late July lows, i.e., before the general perception that a US attack on Syria was perceived as “imminent”, on growing concerns about supply disruptions from Iraq, Libya and Nigeria from strikes and protests that have affected major oil terminals. Oil trading well above $100/bbl of course will act as a tax on the economies of nations most dependent on oil imports, including China and Japan.
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| Source: 4-Traders.com |
Following a plunge in gold price that had some (including ourselves) declaring that the secular bull market in gold was “over”, gold has rallied some 20%, but is still well below the level seen before a selloff sent prices plunging 28% between January and April 2013. If direction of real interest rates is still basically upward, we still see little probability of new highs in gold, even though the recent market uncertainty has hedge funds and other speculators in late August at the highest levels in six months.
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| Source: 4-Traders.com |
More of the Same the Next Few Months
Given that the Fed’s tapering, the debt ceiling fight and the Syrian question cannot be solved overnight, it looks like investors will be stuck with an increased level of uncertainty for the next few months, which implies continued consolidation in equity markets, somewhere between 50-day MAs and 200-day MAs. For the S&P 500, a pullback to its 200-day MA would bring the index back to the 1,550 level, or another 5%, following varying degrees of further consolidation in global equity markets.
Assuming that the secular market trends established since March 2009 remain in place, the following table of 200-day MA levels and current prices indicates that the potential downside risk in an extended correction is greater for the NASDAQ, consumer discretionary, healthcare and Japanese equities, versus upside potential in US long bonds and gold…while crude oil could see a tumble, not a rally. Enhanced returns would be possible in the short-term by shorting the NASDAQ, consumer discretionary, healthcare and Japanese equities while going long long bonds and gold. Once the correction is over, however, these trades would need to be reversed.
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| Source: Yahoo.com |
Central Banks Increasingly Between a Rock and a Hard Spot on QE Wind-Down
Investors remain under the impression that central bank quantitative easing is what has kept financial markets buoyant, papering over still-serious structural economic issues that are the legacy of the 2008 financial crisis. To a certain extent, this is true for financial markts. That quantitative easing is a “free lunch” way to increase wealth, however, is a magnificent illusion, at least as regards the two mandates of the U.S. Federal Reserve, a) employment and b) price stability.
Even the IMF warns that a withdrawal from “endless” QE without a) a significant back-up in bond yields and b) a corresponding bond/equity market correction could be very tricky. As soon as central banks signal they are readying to halt QE (as the Fed has done), bond prices are “likely to fall sharply” as investors head for the door. The backup in rates could force central banks to push up rates even further to prove they have not lost control of inflation, i.e., more fuel on a market correction fire. The IMF warns, “The potential sharp rise in long-term interest rates could prove difficult to control and might undermine the recovery (including through effects on financial stability and investment). It could also induce large fluctuations in capital flows and exchange rates.”
Further, even research by the San Francisco Fed indicates that “Asset purchase programs like QE2 appear to have, at best, moderate effects on economic growth and inflation; the key reason being that bond market segmentation is small. Moreover, the magnitude of LSAP effects depends greatly on expectations for interest rate policy, but those effects are weaker and more uncertain than conventional interest rate policy. This suggests that communication about the beginning of federal funds rate increases will have stronger effects than guidance about the end of asset purchases.”
Total Credit Market Debt Makes the (Economic) World Go Round, Not QE
Thus withdrawal from QE will be tricky for financial markets, while even more QE means minimal impact on the real economy at best and a growing risk of other moral hazard bubbles that will have to be dealt with. How disruptive this attempted withdrawal will be hinges on the movement in total credit market debt, which is the real driver of modern economies, and consists of both private and public sector credit growth. Immediately after the 2008 financial crisis, credit availability from the financial sector’s shadow banking system shrank, taking the economy with it. This shrinkage (plus other private sector balance sheet adjustments) was eventually covered by the public sector, allowing for growth, albeit at weaker-than-normal-recovery levels.
IF the pick-up in private sector credit creation is strong enough, the economy should continue to grow even as the Fed–whose QE-driven credit creation impact was doubtful at best–begins to scale back.
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| Hat Tip: Zero Hedge |
Japan investor tokyo takes 