Normally, I would expect a retest of any significant, cyclical low. But when the low is associated with a spike “V” reversal, the penultimate head and shoulders reversal pattern, the market typically skips the retest. We have had many of these quick reversals in this liquidity-driven bull market. Tuesday’s low fit the pattern.
Nevertheless, I always keep an open mind. Moreover, when the first rally from a cyclical low is sharp and fast, I have to consider that it might be short-covering – rather than confident buyers. So, after deploying our cash close to the bottom Tuesday, the Founders Group sold half the position near the peak on Wednesday. We were stopped out of the remaining position Tuesday night in Globex. We had a substantial profit on the move.
I kept you up to date on the Founder’s Group’s moves on these pages. The option investor, limited to regular session trading, could sell the first half of their position at the peak on Wednesday but did not have the overnight flexibility we have with futures. Still, I set an intraday stop for the remaining half of their position yesterday and advised them not to let the options drop below break-even.
A swing trader must give the market room to breathe – even after a sharp rally. We did so in the Founder’s Group, and then we put our toe back in the water with a half position in the S&P 500 futures at the point where the market should have turned yesterday, assuming a “V” reversal was in place. We used a 10-point stop on the new position. Soon after, our stop hit on the new position, and we hit the stop set for options. The market then sold off viciously, landing back on the Weekly Expected Move low (where the options expire today), which was about the same level as Tuesday’s low.
So we are back to 100% cash, and the issue today is whether this retest will hold. Perhaps more importantly, we have to analyze yesterday’s behavior. Was the market tuned to our original scenario, and something intervened? Or is the market still on the path to the 20-week nominal low we had been anticipating?
In my view, yesterday’s behavior telegraphed a sea change – if the behavior continues beyond a one-off bad day. Not only was the volume heavy on the sell-off, indicating that institutions were raising cash, but the selling was also indiscriminate. Both long-term investors and short-term traders sold everything. They sold copper, precious metals, commodities – everything. This does not bode well for the low holding today. And even if it holds today, we must consider what the market will do once the weekly options’ safety net expected move/expiration low today is not in place on Monday.
Why is this weakness presenting so soon after a low seemed in place on Tuesday? As indicated in my 2021 outlook, inflation pressures have been mounting. The pressures manifested yesterday in the 10-year treasury interest rate breaching our previously identified inflection point at 1.5%. Intraday, the level hit 1.6%. To be sure, rates are still low. Yet the rate has doubled in less than two months.
Looking at the chart, the sell-off in bonds leading to the rising rates is now vertical, indicating emotional excess and perhaps a waterfall decline bottom soon, at least for now. So I would not be surprised to see rates back off a bit, which would allow the stock market low to solidify. I cannot be sure, but that is my best judgment.
One might postulate that rising rates reflect a recovering economy. That should be good for stocks and earnings. A steepening yield curve normally precedes rising growth. All should be well.
Truly, growth is improving. But here, I believe that the market is concerned about stagflation. Stagflation is what we had in the 1970s—stagnant growth with high inflation.
While stagflation requires an entirely separate discussion, let me distill it down to a couple of important points. First, the Biden administration’s initial moves have been anti-growth. So, rather than celebrating potential growth, market participants are concerned about the administration’s moves and that the Federal Reserve is losing control of inflation and rates. All of the Fed’s activities and authority centers around short-term rates. It is by manipulating short-term rates that the Fed attempts to influence longer-term rates.
The rate that really counts is the 10-year treasury interest rate. Most loans are tied to that rate, including home mortgages. In fact, in four of the last five months, home purchases have been down. Higher rates will make that worse. Higher rates will negatively impact growth and recovery.
While the ultimate interest rate is important, also of concern is the velocity or delta of rates. Rates are not just rising. They are rising at an alarming pace. That makes yield curve control even more challenging. Here, I believe that the market is focused on the untargeted stimulus set to pass Congress today.
Money is going to people who are likely to spend it. This has more potential to induce demand-driven inflation as opposed to past actions of the Fed, where they liquify the banks – allowing the banks to loan funds in a more discriminating way. That is less inflationary and one reason why increasing the money supply in the past 40 years has not been inflationary.
Supply chain disruptions from the Pandemic have already led to shortages and rising costs. Lumber, steel, copper, and other raw materials are at 12-year highs. There are shortages in microchips. The Texas utility crisis will further drive demand. Most importantly, substantial debt is rolling over in 2021 in the government, corporate and commercial real estate sectors. In fact, the debt at issue is the most leverage in the recorded history of the country. Rolling over this debt, or the inability to roll it over due to rising costs or tighter lending standards, pose significant structural risks to the economy. These are major issues for the government and corporate bond markets.
The Fed’s mandate is to fight inflation but maintain as close to full employment as possible. If costs are rising – whether they be financing costs or costs for raw materials and labor – this could impede growth and lead to more layoffs. If the Fed loses control of rates or investors experience a confidence crisis in the Fed’s available tools or the currency, economic circumstances could deteriorate quickly. To control long-term rates, the Fed will need to buy longer-term bonds than it typically does as part of its quantitative easing. Other than that. the tools are limited and unpleasant for stock market participants.
I know this is boring stuff first thing in the morning, but it is important to understand the issues at hand. The bottom line is that the rising rates, together with the pace at which they are accelerating, is causing market participants – especially the smart money – to reconsider their strategies. The fact that inflation fears are driving rates higher (rather than growth expectations) is why the rising rates affect the stock market even though the rates are still low. The stock market will tolerate higher rates that are associated with growth expectations.
For our part, no algorithm or indicator will guide us here – we have to use our brains. We have to be very, very careful.