I don’t want to get ahead of myself, but given this morning’s 19 S&P handle gap lower, it looks like the bear might have finally wandered into an area where he can’t be ignored.
I knew we were getting closer to something bad happening when earlier in the week we had the first decent down day and the jokes about buying the dip because “there is no such thing as two down days in a row” were running thick. It has been a long time since stock market traders have experienced any sort of risk to the downside and I think they might have forgotten what it feels like.
Now maybe the bulls will be able to miraculously turn this thing around, but I don’t think that is the right bet.
Yesterday’s trading strikes me as the last gasp from the bulls for a little while. Why do I feel that way? Let’s have a look at the trading from yesterday.
The big news all centred around the release of the FOMC minutes. The initial market moving headline was the fact that the Fed allowed news to be made with the minutes providing guidance about the final remainder of $5 billion tapering. There has been some speculation about whether the Fed would taper $5 billion in the final meeting of 2014, or whether they would do $15 billion in October. That speculation was put to bed with the release of the Fed minutes:
Some committee members had been asked by members of the public whether, if tapering in the pace of purchases continues as expected, the final reduction would come in a single $15 billion per month reduction or in a $10 billion reduction followed by a $5 billion reduction. Most participants viewed this as a technical issue with no substantive macroeconomic consequences and no consequences for the eventual decision about the timing of the first increase in the federal funds rate–a decision that will depend on the Committee’s evolving assessments of actual and expected progress toward its objectives. In light of these considerations, participants generally agreed that if incoming information continued to support its expectation of improvement in labor market conditions and a return of inflation toward its longer-run objective, it would be appropriate to complete asset purchases with a $15 billion reduction in the pace of purchases in order to avoid having the small, remaining level of purchases receive undue focus among investors.
This caused an initial sell “the end of QE” dip in the stock market. But as market participants digested the rest of the minutes, they quickly came to the conclusion that even though the Fed was ending QE, they were miles away from hiking rates. This caused a made scramble higher in various financial assets.
S&P Trading over the last three days</a> </div>
The market’s interpretation of the Fed minutes is even more obvious when you have a look at the short end of the yield curve. Here is the chart of the Sep 2016 Eurodollar contract.
Sep 2016 Eurodollar Contract (higher price means lower yield) over the last 3 days</a> </div>
The release of the minutes is obvious to see. There was also a small move lower, but then the contract rallied hard into the bell.
And if you don’t believe that the market viewed the release of the Fed minutes as pushing rate hikes into the future, have a look at the chart of gold.
Gold trading over the last few days</a> </div>
I believe that yesterday was an inflection point where the market received good news in terms of the Fed’s reluctance to hike, yet that prospect has been fully “baked in.”
There is even a chance that we have reached a point where the Fed’s cluelessness regarding their overly easy policy is going to scare market participants.
Lately I have been pounding the table on being long commodities and short financial assets. The market might be finally waking up to the fact that the Fed can print all the money they want, but it does not mean it will always go into the asset that the Fed wants.
S&P (yellow line), Fed Balance Sheet (green line) vs CRB (white line)</a> </div>
Eventually the market is going to realize that the Fed’s largesse cannot create real growth – only nominal growth.
I believe that the Fed will accept this nominal growth over general price deflation, but I think the financial markets are being fooled. There has been a mistaken belief that the inflation will be confined to financial assets and that the Fed can control this great monetary science experiment that they have conjured up in their basement.
Recently the market often seems confused by the guidance offered by the various Fed officials. The reason the market is having trouble interpreting the Fed’s intentions is because the Fed itself has no clue how it is going to exit this monster mess they created. All they know is that their balance sheet is extremely large, and due to the large state of general indebtedness, the economy’s recovery is very sensitive to rises in interest rates. The Fed is trapped and the market has not realized it yet.
But eventually the market will figure it out. At that point, the prospect of the Fed falling behind the curve might actually scare the market and cause financial assets to decline, instead of rise. We might be reaching the point where the market realizes the emperor has no clothes.
I realize that this morning we have problems in Europe that are also dragging the market lower. But don’t forget that the markets make the news, not the other way round. If the bull was ready to continue they would have found a way to spin the news in Europe positively. Over the last couple of months, how many times have we seen news that should have caused the market to sell off that was merely greeted with more dip buying? All news was previously good news. The fact that we are interpreting bad news with selling might mean that we are finally ready to correct.
I hope this post generates lots of sneers about how I missing out by not buying the dip. Nothing will convince me more that I am more right than receiving the scorn of the bulls. It is when they agree with me that I will be worried…
In the mean time, watch out for the shift in sentiment away from financial assets into hard assets. The market is not set up correctly for the Fed’s dangerous experiment with extremely easy monetary madness. An easy Fed does not always mean that financial assets rise…