Fear is a great motivator

The market has been drifting lower since my last post and is back to the lowest point since the decline that began in early May started. I've mentioned how sentiment has been moving towards a bullish condition and it has moved even further still, however, it feels like to me that the market wants to head lower and we could very well see a whoosh down as  "support levels" get broken but with sentiment already negative as it is, such a sell-off should lead to the type of extremes you see at intermediate term lows rather the beginning of something much worse.

What's troubling the stock market? Seems to be the bearish message of the bond market is becoming too hard to ignore as inversion sets in even further along with some weaker than expected economic reports and of course, the trade drama which might be contributing to the  weaker data. It would seem these troubles are largely self inflicted. The bond market is clearly telling the Fed that it made a mistake with its last couple of rate hikes. Trump is trying to bully China like he did with Canada and Mexico but China is not caving in. It might very well have to be the case for the market to have a breakdown of significance to light a fire under the ass of government authorities to take a different course of action as it did in December and in all the other major declines since 2008. Fear is a great motivator.

Powell's bathwater must be getting really hot again. He must certainly now realize he made a mistake hiking in December. How can he not with the 2 and 5 year treasury bonds only 10 bps or so away from 2%? So when will the Fed cut rates? Are they going to wait until it's painfully obvious (and too late) or will they have the stones to do it sooner? A sharp decline in the stock market could do the trick again. Futures market is putting the odds of a rate cut by 2020 at 80%! Is this the case of the tail wagging to dog or the other way around? Powell once believed he was the dog but last December showed it was Mr. Market who was the dog!

Let me circle back to sentiment again. If we ignore the inversions, trade drama and such and just focus on the sentiment stats, it would appear that any downside we do get from here should be relatively limited because sentiment is already negative. I read an interesting report  a couple weeks back released by Bank of America which showed that global fund managers as a group ($600 billion assets) were underweight equities by one standard deviation, overweight cash and overweight bonds (7 year high weight). If you look at the history of this report on the positions of global fund managers it has served as a great medium-long term contrary indicator.

All in all, what I'm sensing is that although market action and some fundamental metrics such as the bond market inversion are sending bearish signs, if we do get a breakdown in the market it should likely set the stage for a low rather than the beginning of something nastier. Let's take it one step at a time and adjust accordingly if need be. As mentioned last post, navigating the ST is a tricky affair. The shorter the time frame the more randomness plays a factor. There can be a lot of noise which creates whipsaws especially when you have the Donald and his twitter account.

Blink and you miss it

AAII sentiment did a big u-turn this week showing bulls dropping to 30% and bears spiking to 39%.  Since the correction that began in early May started, bond yields have dropped notably back to YTD lows and we've seen fund flows go firmly negative. Put buying has exploded too even in the face of the strength these few days including today.  All this make fertile conditions for at least a ST bottom and I suspect we've probably seen the lows of this correction and we should be looking for long entry point here. I know what you're thinking....it would have been nice to know this a few days ago when the market was lower and I agree.  The problem is the sentiment data I track  is released weekly which means you may not be able to react to it at the ideal time.  Admittedly, I was hoping for the market to get a bit more oversold too, but alas, the market doesn't always give you what you want. In recent years it's been more common to see the market do V shaped recoveries which is frustrating for me. What this means is that you gotta risk catching falling knives if you hope to buy near the low points. If not and you wait for confirmation first, it can be hard to pull to trigger knowing you could have bought lower or you fear a retest of the lows which never ends up happening. Staggering entry points could be a way to overcome this....use say up to 50% of your intended position to buy during major weakness and the other 50% only when there's some sort of  confirmation. 

It's also important to not get too caught up in the ST wiggles of the market and think  more longer term because the ST is often very tricky to navigate through. and riding the bigger trend is where you can make big money. I found a really nice nugget of information suggesting that this market still has a long way to go before we get to the point of too much optimism. I'll share that in a later post.

The message of the bond market

Yields on US 2 year and 5 year bonds are now at about 2.18% which is notably below the Fed funds rate of 2.50%. I've discussed the meaning of this before but I want to rehash my thoughts here. Historically, when we've seen this it's a signal that the Fed is going to cut rates in the not too distant future i.e. less than 12 months and such a thing would typically be associated with a response to perceived economic weakness and if such a rate cut happens after a campaign of rate hikes, it has typically been a signpost of the economy rolling over into a recession, but that hasn't always been the case. In mid 1995 the fed cut rates by 25bps after having hiked them continuously in 1994. At that time, the market was near all time highs and there was concerns over economic growth. After that cut the market continued to make new all time highs and never looked back for years and the fed still cut rates another 50 bps before they stopped.  Here's what a headline from the NY times said back then:

"Under mounting political and economic pressure to stave off a possible recession, the Federal Reserve reduced short-term interest rates today for the first time since 1992.
Investors in the markets had been awaiting this meeting for weeks, as speculation intensified about how the Federal Reserve might respond to a string of Government statistics that showed a sharp slowdown in business activity. Some Fed officials as well as investors had begun to worry that inaction could lead to a plunge in the stock and bond markets that might make a recession more likely."

No two periods play out exactly the same but there can be rhymes. Given the pressure that Trump is putting on Powell and negative implications of tariffs at a time when there are  concerns about the economy as it is, we could indeed see rate cuts sometime this year. I'm sure lots of people would call a rate cut madness when we are at record low unemployment levels and no material indications of a recession, but the bond market is saying that rate cuts are going to happen. I called Powell's last hike in December a mistake and the bond market is pretty much saying the same thing, but like in 1995, if the fed were to cut rates and thereby admit they over-tightened a bit, it doesn't necessarily spell doom. In fact, it could be opposite. Look at how the market reacted in January when the Fed simply  backtracked on their plans for further hikes in 2019.

As I've said before major downturns are preceded by greed/complacency which we did not see prior to this drop in the market. You could argue that we did see such greed/complacency in early 2018 which I was pointing out, but I just don't think that it was such an extreme to have marked the end and furthermore, after the December meltdown the complacency of early 2018 got completely extinguished and has been replaced with worry. With the Uber and other "unicorn" IPOs that have recently came out, you could argue that greed/complacency was creeping back in, but as I've been pointing out repeatedly, there's been no equity inflows and a general lack of exuberance from the pundits/financial media as well. And let's not forget the fact that the market was up 18%  in 4 months...at some point it had to rest otherwise we'd be on pace for a 50%+  gain in 2019 which is pretty much impossible.

I know much of what I stated is arguable. So many things are subject to one's interpretation but that's just the way the it is. The market is not an exact science.  So, what is one to do? I say be pragmatic and tactical. Look for buying opportunities when there's signs of extreme negativity/capitulation and sell when you see complacency. In other words, only act when you see a perceived edge. If not, sit on your hands. But you got to be anticipatory to some degree. If you just wait for everything to be rosy you'll miss out.

AAII buys the dip

One of the key sentiment indicators I track AAII, is showing complacency in the face of market weakness. Bulls actually increased this week to 43% vs only 23% bears (34% neutral). When AAII buys the dip like this it's usually not a good sign for the market in the short term and when it's 2:1 bulls vs bears it's not an ideal time to buy regardless.  We've also had a lot of IPOs lately and so when combining all this with the latest Trump hissy fit, we shouldn't really be too surprised that the market is correcting here. We have had a hell of run so far this year and at some point the market has to cool off for one reason or another. As always, I'll keep an open mind as to whether this is the start of something really nasty but I don't think so at this point given what I discussed in my previous post. We'll see how things unfold....I am not considering any new buys untill I see AAII get bearish again and the market gets oversold.

The song remains the same

I continue to be amazed how this market is still not attracting buyers from retail investors. Here we are at new all time highs (albeit marginal) and yet STILL no positive net inflows! Compare this run in the market to the similar one from Sept 2017 to January 2018 where there was heavy inflows. Of course, back then we had all the "Global synchronized growth" chatter whereas now there it's the opposite. It's comfortable to buy when things look rosy like back then,  but it's also more dangerous because as I've said here many times, it's all about expectations. When expectations are high, lots of people get in the pool and all it takes is slight disappointment for there to be a severe correction.  Now we a have a situation where the market is rising relentlessly yet expectations have been fairly low all throughout it. That makes the rally likely to be a sustainable one with any dips likely to continue to be shallow.  What will it take for people to jump back in? Probably clear cut signs that the global economy has returned to growth mode, but the market is forward looking and so by the time you wait for the all clear you will have missed a lot of the move. But wait a second, what about the bearish signal of the bond market? Government bond yields continue to be low and bears are pointing this out as a non-confirmation of this rally i.e. the bond market sees things differently than the stock market and that the bond market is smarter. Well, I have seen times when the stock market has been smarter. Take for instance the behavior of the stock market vs bond market after the recession scare of 2011. The stock market correctly rallied in 2012 and 2013 which was not "confirmed" by the bond market until the first quarter of 2013. Oh but there was QE  back then and yada, yada, yada. There perma bears like zerohedge and the like have been making excuses since day fucking 1 and must of cost people who follow them God knows how much.

The bottom line is as I said before, .major corrections start AFTER there had been a major rise in bond yields. The greater the preceding rise in bond yields, the greater the correction tends to be. We have only seen a minor pop in yields since the end of March which suggests any correction at this point would be minor; the same message being given by the non-existence of fund inflows. Continued low bond yields and lack of exuberance  from mom and pop investor suggests the market can still power forward a lot higher before it's all said and done.