Market Analysis

What If

What if bears were right all along? What if it’s not different this time?

What if this Fed liquidity inspired rally produced precisely the kind of exuberant final thrust we often see at the end of business cycles? After all, people were really bullish in 2007, people were really bullish in 2000, both final rallies inspired by easy Fed liquidity. In 2000, the Y2k bug, in 2007 giving us the subprime mortgage crisis.

What if this latest rally has produced exactly the same conditions we’ve seen during prior tops?

Be clear: I’m not calling for a top here, that’s a fool’s errand. After all so far all we’ve seen is a minor pullback off of very overbought conditions. Heck, tech hasn’t even begun to correct yet.

But yields keep dropping like a brick, as does the Baltic Dry index, small caps, transports, the banking sector never confirmed new highs, equal weight indicators suggest a major negative divergence inside a market that appears entirely held up by tech, and perhaps by only 5-10 highly valued stocks that are massively technically extended and control more market cap in a few stocks than ever before. At the same time we have a market more extended above underlying GDP than ever and now suddenly a potential trigger nobody saw coming: The coronavirus.

Look, the track record on viruses and diseases over the past 20 years has been clear: Any market impact is temporary and/or minimal at best. Look at SARS in 2003, $SPX rallied over 20% in 2003. But the backdrop was different. The US just came out of a recession and markets had bottomed in 2002. Markets in 2003 were at the beginning of a new business cycle.

This cycle here is old, and one could argue was merely saved again by a Fed going into full easing mode in 2019.

But given the fact that the Fed failed to normalize in the lead up to 2018 and was stopped dead in its tracks because of a 20% market correction and was forced to go back into full easing mode the concern is that the Fed just wasted precious ammunition.

My concern:

These very concerns now suddenly very much echoed at Citi:

None of us can know how this plays out, we can’t know when this virus will be contained and subsides. What we do know is that the economic impact is already real, flights are canceled, businesses are shutting down in China, etc.. To the extend that this is all temporary for a couple of weeks, fine, to the extent it drags on for months and the virus spreads quickly in other countries as well it’s not hard to imagine that a vastly richly valued market finds itself in trouble and with it: The global economy.

Markets, except tech, pretty much gave up all their gains in January with many indices now in the red. The potential good news for investors: Markets are approaching oversold readings and could be setting up for a bounce, and a larger relief rally if the news on coronavirus shows improvement, the bad news: Tech hasn’t even begun to correct and technical patterns suggest more downside risks.

And if bears have been right all along on the macro front, then rallies may well remain selling opportunities. And so far, strength in January has proven to be a selling opportunity on the larger market.

For now it’s a ‘What if” and confirmation remains outstanding and won’t come easy. But clearly some of the major banks are starting to ask similar questions.

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6 replies »

  1. Excellent and even handed analysis, Sven. Probably too even handed IMO, the risks look well skewed to the downside for the next week or so at least. Been following you for about a year and think your perception of what’s going on is pretty spot on.

    I think the sharp bounces and declines that will probably happen once the first phase of decline has played out merits investment in someone with antenna like yours. I expect my current bets to provide the funds to do that next week 😉

  2. Sven,

    It is logical that the markets have a decent chance of correcting more that 10% due to the coronavirus sparked black or grey swan, yet it really depends on a couple of things that logic can not predict or define:

    Does the Fed drop rates another 0.50-1.00% in 2020?
    Does the fed increase “Not QE”, instead of reducing it in 2020?
    Does the coronavirus spread rate decrease in mid February, mid March, mid April?
    Do the world governments further animal spirits or accidentally induce animal panic?
    Does the “orange swan” help or hurt global markets in 2020?

    “IF” the world central banks had allowed the global recession to proceed naturally back in 2015/2016 (at a more natural 4-5 year pace instead of 10-12 years), right now we would be in a situation that could more easily handle a possible pandemic. SP500 at 1800 would be at no real risk of panic versus SP500 at the highest valuations in human history, via numerous metrics such as price per sales. Someday A.I. will be able to predict all the unintended consequences that our leaders fail to imagine…so until then, boom/bust will define our future.

  3. Markets may correct due to overbought status, but that’s just a buying opportunity for stocks. Market behavior is now an extension of the widely used 60:40 (stock/bond) portfolio distribution. Today, investors are adding to the bond ‘40’ part of their portfolios due to the ‘60’ stock portion exceeding the 60% threshold by a wide margin. When the bond buying stops you’ll see a surge into equities to rebalance yet again to maintain the ‘60’ portion. Investors have no choice but to sell stock and put it into bonds (unless they use new money to buy the bonds).

    Stock valuations no longer matter in world where central banks control the markets. Yes, if Bernie is elected the Fed will suddenly believe in free markets again, but unless that happens I’m just waiting for the next rate cut and a massive QE program, which will be implemented to counter ‘global economic uncertainty’.

    Gold and silver will also do well in such an environment.

    Could there be a come to Jesus moment for markets if the virus goes global- yes, but it will be considered one of the greatest stock buying opportunities of all time.

  4. i find it humorous that a 3% drop in the markets can elicit a literal freak out by just about everyone associated with wall st. we are at stretched historical valuations screaming for a reversion. i cannot even begin to imagine the meltdown that ensues when markets correct 50% which would be a run of the mill bear given the valuation extremes.

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