How Far Will the Stock Market Rebound Go?

October 20, 2014

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Courtesy of Pater Tenebrarum of Acting-Man

A Brief Look at the Technical Backdrop

We can actually not answer the question posed above with certainty. We don’t know for sure whether the recent market decline was a “warning shot” or merely a short term shake-out. In this we are in good company: the whole world doesn’t know.

However, our guess at this juncture is that the decline was of the “warning shot” variety, as it has violated long-standing uptrend support lines – something that the market has managed to avoid in previous corrections over the past three years. There are also fundamental reasons for thinking so, which we discuss briefly further below. However, based on fundamentals alone, it cannot be determined whether the stock market is already “ripe” for a larger degree decline, or whether its uptrend will resume in the short/medium term.

To be sure, the technical picture certainly conveys no certainties about the future either. However, should the market peak at a “typical” retracement level or at a previous lateral support level (thereby confirming its new status as resistance) and resume its decline from a lower high, yet another change in character will be recorded. In that case, the probability that a larger degree decline is underway would accordingly increase further.

Below are charts of the most important indexes showing Fibonacci retracement levels of the recent correction and lateral resistance levels. Although it is unknowable why the market often finds support or runs into resistance at Fibonacci retracement levels (there is certainly no logical reason for this), it has happened quite often in the past, so it is useful to be aware of them. Possibly it has become a self-fulfilling prophecy, because so many traders use technical analysis nowadays.

The first chart shows the S&P 500 Index (SPX), the NYSE Composite (NYA), the Russell 2000 (RUT) and the RUT-SPX ratio. What is noteworthy is that the Russell outperformed the large cap indexes from Monday to Thursday, thereby giving slight advance warning of an imminent short term low. However, this streak ended on Friday. Whether that was just a short term blip remains to be seen, but one should continue to keep an eye on the Russell’s relative performance. If the action on Friday was the start of another period of underperformance, it will represent a fresh warning signal. Note that large speculators have amassed a fairly large short position in Russell 2000 futures. In the short term, this may invite some additional short covering. However, speculators have largely been correct with their bets on Russell futures over the past decade (apart from a brief moment in the summer 2011 correction).

SPX, NYA, RUT and RUT-SPX ratio. Fibonacci retracement levels and nearby lateral resistance levels – click to enlarge.

The next chart repeats the above exercise for DJIA, Nasdaq and NDX.

DJIA, Nasdaq and NDX. All the major indexes have essentially bounced back to the 38% retracement level that is generally regarded as the minimum target for a rebound. 50% and 62% rebounds tend to be more common per experience, but there can be no assurance that either of them will be reached – click to enlarge.

Sentiment Data

Below are charts of a few sentiment data, mainly short term oriented ones (long term sentiment indicators are still at levels that are among the most extreme on record – specifically, mutual fund cash levels remain close to a record low, while margin debt is still close to a record high). The first three indicators are the equity only put-call ratio, the Rydex bull-bear ratio and Rydex bear assets:

The equity put-call ratio is in “signal-less” territory at the moment, but the Rydex bull-bear ratio is close to its year-to-date low, while bear assets are close to a year-to-date high. However, they remain at levels that have either only been recorded in 2014 and 2000 (bull-bear ratio) or solely this year (bear assets remain in a range that is the smallest in history) – click to enlarge.

Next we take a look at the Investor’s Intelligence survey. The percentage of bulls in this survey (which was taken on Wednesday, when the market reached its intra-week low) has not surprisingly declined quite a bit, but has happened with the bear percentage is quite remarkable. Just as Rydex bear assets remain within their lowest range on record, the bear percentage in the II poll has risen to a mere 17.3% – which used to be considered extremely low in the past.

The Investor’s Intelligence Poll. Why is the percentage of bears still so tiny? – click to enlarge.

The reason why we are bringing this up is that there has never been an important correction low with the bear percentage in the II-poll at a mere 17.3%. Normally we see it swell to between 40%-50% (see 2011) at major correction lows and it tends to at least approach 30% in minor corrections (see 2012). 17.3% is normally consistent with a market peak rather than a low.

What this and the extremely low level of bear assets in the Rydex funds is telling us is that practically no-one expects a big decline. Many investors and investment advisors seem to be allowing for a correction, and may even concede that it could become larger, but very few seem to be concerned about the potential for a really big downturn. This is a negative contrary indicator for the market.

Fundamental Backdrop

It is clear by now that the economies of the world ex the US aren’t performing particularly well. China’s economy is slowing noticeably after money supply growth fell to its lowest rate of change in many years, which has impaired the country’s real estate bubble. Since China’s authorities seem to be set on continuing to move the economy away from overbuilding and massive capital investment, no significant monetary stimulus measures should be expected in the near future.

What strikes us as remarkable about the situation in Europe is that all it took for the ongoing economic malaise to become a “triple dip” recession, was a slowdown in true money supply growth from a peak of 8.6% to a recent 6% year-on-year. This is noteworthy, because it is the first empirical confirmation of our long-held suspicion that the “threshold level” at which a slowdown in money supply growth unmasks various bubble activities in the economy has increased.

We suspect that something similar may apply to the US economy. While the broad US money supply TMS-2 most recently still grew at a historically high rate of approx. 7.6% y/y, this represents a massive slowdown from the approx. 16.5% to 17% peak levels of late 2009 and late 2011. At the same time, the economy remains quite imbalanced. The ratio of capital to consumer goods production has continued to climb and is currently just down a smidgen from a recent new all time high. If one compares capital and consumer goods production side-by-side, there is now an unprecedented gap between the two. We believe this is a result of the artificial suppression of interest rates by monetary pumping. Note in this context also that the huge issuance volumes in the junk bond market in recent years are by themselves already indicating that a lot of malinvestment is in train. These economic activities would under normal circumstance never get this much cheap funding. We can be quite certain that a lot of the associated investments will eventually turn out to have been misguided.

The ratio of capital goods (business equipment) to consumer goods production in the US has reached a new all time high recently – click to enlarge.

Only two times in history has capital goods production in the US exceeded consumer goods production (the red line shows consumer non-durables production, which has barely increased since the 2008 crisis) – click to enlarge.

Such economic statistics must of course always be taken with a grain of salt; for instance, monetary inflation is certainly not the only factor in the rising long term trend of US capital goods production exceeding consumer goods production. Partly it can be explained by the fact that a lot of consumer goods production has moved off-shore. Even so, there are still discernible fluctuations, which are mainly the result of boom-bust cycles induced by monetary pumping.

When interest rates are artificially suppressed by large additions to the money supply, more and more investment tends to move toward production processes temporally distant from the consumer stage. This is because under conditions of monetary pumping, price signals in the economy are falsified. Longer production processes that would normally be avoided because they are not in line with society-wide time preferences suddenly appear to be profitable, and it is only later revealed that either the real resources to complete them are lacking, or if they are completed, that they simply cannot be continued without incurring major losses once the price structure has normalized.

Usually this normalization in relative prices occurs once monetary policy becomes tighter – and this is indeed happening now (“tapering” of QE is tightening, even if the Federal Funds rate remains at rock bottom levels).

Lastly, given how poor the economic recovery has been overall, we can tentatively conclude that the economy’s pool of real funding has sustained severe damage in the preceding credit boom(s), and has undoubtedly been weakened further in the most recent one.

For the stock market (and other “risk asset” markets like junk bonds and also higher rated corporate bonds) this means that the fundamental backdrop that makes a major denouement possible is definitely in place now. However, we cannot state with certainty whether there is still room for the imbalances to grow even further. What we do know for sure is that the risks appear very high already.

Conclusion

In the past few years the stock market has always recovered from corrections to make new highs, and we cannot be sure if the party is indeed over. However, both from a fundamental and technical perspective, the probability that it is over seems quite high. Should market internals and trend uniformity to the upside improve again, this assessment would obviously have to be revised. However, there are surely more than enough warning signs extant now and every financial asset bubble must end at some point.

As an aside, in spite of the heavy cooing by various Fed doves last week, we don’t think the present course toward tighter policy will be abandoned immediately. For the Fed to actually react, a lot more damage would likely have to occur in asset markets and economic data would have to become uniformly negative, which is so far not the case in the US. The danger that it will happen – i.e., that similar to Europe, the slowdown in money supply growth will render numerous bubble activities unprofitable – is however great.