In yesterday’s missive “It All Comes Down To This,” I discussed the upcoming Federal Reserve meeting and the expectation that the Fed once again delays hiking rates due to global economic and market weakness.
With markets oversold on a short-term basis combined with a spike in volatility and bearish sentiment, a “punt” by the FOMC will likely spark a short-term rally in the market. Such an outcome would not be surprising by any means since the market has rallied the week of an FOMC “no hike” meeting since 2013.
However, those with a “bullish bias” should not become complacent in such an outlook as any rally will likely be short-lived. Let me explain.
A Change Of Trend?
As I have often written, markets do not rise or fall in a straight line. During bull markets, there are declines to previous support levels and during bear markets there are rallies to resistance.
Notice that at the peaks of previous bull markets, the initial correction looked much like all previous corrections during the bullish advance. The problem is that many failed to recognize, until far too late, the technical trend had changed for the worse.
Currently, it is being argued that this correction is just a blip in an ongoing bull market. However, there are plenty of markings that suggest that the current correction may have been the start of the next cyclical bear market.
A 2-4 Week Rally
As stated above, FOMC meetings that have not resulted in a “tightening” of monetary policy have consistently ignited short-term rallies in the market. As shown in the two charts below, sentiment and volatility have reached levels suggests sellers, at many levels, have been exhausted.
While the volatility index (VIX) is still suppressed relative to historical corrections, it is at the highest level since 2012. When combined with the most bearish sentiment reading we have seen since the summer of 2011, and a currently oversold market condition, the ingredients needed to fuel a short-term (2-4 week) rally are present. A delay by the Fed could be the spark needed to bring speculative buyers back into the market.
The chart below shows this oversold condition and is the same “potential reflex rally” chart I have posted for the last four weeks. The blue dashed line that I drew immediately following the initial slide has been marking the exact “reflex rally” I predicted at that time.
As I addressed last week, any rally back to those resistance levels will likely fail given the deterioration in both technical, fundamental and economic underpinnings. A failure at those levels will also be consistent with the previous transitions of “bull markets” into “bear markets.”
Deja Vu All Over Again…
That transition was noted by Henry Blodget recently:
“As markets have calmed, the debate about whether we’re in the early stages of a full-on crash has quieted.But don’t get too comfortable. This is still an open question.At times like these, it’s helpful to get a historical perspective. And what you find when you do that is that no one who is concerned about a crash should take comfort in the market’s recent stabilization. Why? Because market crashes take time.The market’s recovery from the August lows might, in fact, be a ‘buying opportunity’ that is the beginning of another surge to record highs. But it also might be one of those bear-market rallies that have punctuated nearly every major market collapse in history.”
The following three comparative charts support his view. Notice that following each initial decline there was a subsequent “suckers rally” that failed. It was the last opportunity to exit the market before the “crash” occurred.
As noted by John Hussman:
“Market crashes ‘have tended to unfold after the market has already lost 10-14% and the recovery from that low fails.’ Prior pre-crash bounces have generally been in the 6-7% range, which is what we observed last week …”
Is this the beginning of a “market crash?” Maybe? Honestly, no one knows for sure because crashes are fueled by a panic-driven selling exodus from the markets generally due to some sort of financial shock.
However, the markets are certainly set-up currently to trade within a more “bearish”trend which puts investors at risk. How much risk? That is something that John Hussman also commented on in his latest missive:
“We fully expect a 40-55% market loss over the completion of the present market cycle. Such a loss would only bring valuations to levels that have been historically run-of-the-mill.”
Even if such an outcome does not occur, it is quite likely that given current valuation levels, deterioration in earnings growth, and a slower economic environment, that forward returns will be substantially lower. In other words, the “risk-reward” ratio for being an aggressive investor at this point in the market/economic cycle suggests that the “house will likely win.”
It is Deja Vu all over again…