The bounce I forecast in my last note from 16 October (Indigestion turns to stomach ulcers) has played out very nicely. I was looking for this bounce to last into this week, but points-wise it has actually been a little stronger than even I expected with the S&P 500 closing on Friday above my 1905 weekly closing pivot level.
I should therefore be moderately bullish. But things do not feel right on the bounce – underlying deep price action and flows, together with the extent of the moves in headline indices/indicators, which diverge heavily from some key risk indicators, leave me feeling very uncomfortable. In this context the 'markets' aggressive attempt to define what we saw during the risk sell-off – which actually began in September and lasted for a month from high to low (in say S&P, 19 September the high to 15 October the low) and not 'just a couple of days in the week of 13 October' – as being driven by a set of isolated idiosyncratic risk factors (ebola, Shire, Pimco etc), leaves me concerned. Why? Because it tells me that markets are still refusing to accept the real drivers, namely mounting evidence of weak global growth, strong deflation, and growing policy gaps/credibility concerns. As such my concern is that once the market is reminded/accepts that we have broad-based problems and not just a few unfortunate idiosyncratic hits, then the reprice of risk will resume.
In respect of my 1905 pivot level and the bounce that commenced almost on cue on the early morning of 16 October, I would now be positioned very close to home. This week (the FOMC meeting, US GDP data) will I think be key and will set the tone for markets for a few weeks, certainly into nonfarm payrolls next Friday and likely through to later in November.
On balance I think the S&P 500 (as a proxy) could rally 75 points (+/- 25) over the next two to three weeks, or it could drop 200+ points.
Assuming one rode the bounce from 16 October, I think the risk/reward now is to be very close to home, and one either waits for new highs in risk (2020 on S&P) before getting involved again, or one waits for violation of 1905 again, in which case I think there would be easily be another 150+ points to the downside to capture.Apologies that I cannot be more precise at the time, but I really do think that the next week or so will set the tone for markets for the rest of Q4 2014, so I think patience will be rewarded.
As I noted last week, “Keep in mind that even terribly hostile market environments do not resolve into uninterrupted declines. Even the 1929 and 1987 crashes began with initial losses of 10-12% that were then punctuated by hard advances that recovered about half of those losses before failing again. The period surrounding the 2000 bubble peak included a series of 10% declines and recoveries. The 2007 top began with a plunge as market internals deteriorated materially (see Market Internals Go Negative) followed by a recovery to a marginal new high in October that failed to restore those internals. One also tends to see increasing day-to-day volatility, and a tendency for large moves to occur in sequence.”
My impression is that we are observing a similar dynamic at present. Though we remain open to the potential for market internals to improve convincingly enough to at least defer our immediate concerns about market risk, we should also be mindful of the sequence common to the 1929, 1972, 1987, 2000 and 2007 episodes: 1) an extreme syndrome of overvalued, overbought, overbullish conditions (rich valuations, lopsided bullish sentiment, uncorrected and overextended short-term action); 2) a subtle breakdown in market internals across a broad range of stocks, industries, and security types; 3) an initial “air-pocket” type selloff to an oversold short-term low; 4) a “fast, furious, prone-to-failure” short squeeze to clear the oversold condition; 5) a continued pairing of rich valuations and dispersion in market internals, resulting in a continuation to a crash or a prolonged bear market decline.
Note in particular how similar the 2007 and 2014 market behaviours are:
2007 and 2014:
first a climb and a drop
then a longer climb and a larger drop
then a quick recovery to the cycle high
then an even larger drop
and a quick recovery
And, of course, don't forget ZeroHedge's laconic comment on stock market volumes: "LOL"
(FYI: very high volume on every down day, and very low volume on all up days the last week)