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posted on 21 February 2016

Market Bounces, Now What?

by Lance Roberts, Clarity Financial


As opposed to last week, the market action during the first half of this past week was much more positive. What was interesting, was despite the absolute drubbing that investors have taken since the beginning of the year, the three-day advance saw a surge of "bulls" running into the fray "claiming victory" over the bears. This is hardly the case.

In last week's missives, I discussed the potential for an oversold, short-covering bounce which was to be used to further rebalance portfolios and reduce equity risk. The target zone was 1940 to allow for the completion of the "risk reduction" process.

"On a very short-term basis the market is oversold and the bounce on Friday was JUST enough to close above the October lows support at 1860. Any continued rally next week should be used to further reduce equity risk and rebalance portfolios."


"However, market bulls will argue, and correctly so, that the continued retests of the 1860 level by the markets is building bullish support for the market. However, this action is not uncommon at major market peaks as it takes time to erode bullish "hopes" to the point those supports finally give way.

With the markets once again oversold after last week's fairly brutal sell-off, a rally is expected over the next couple of days to allow portfolio risk to be rebalanced. That rally could take the markets back to the previous resistance of 1940 (about a 4% push) from current levels. Such a rally would be enough to suck many of the "bulls" back into the markets pushing markets back into overbought territory and setting up the next decline."

I have updated the chart above, below. As discussed last week, the "bulls" did come stampeding back into the market as expected which pushed the markets back into extreme overbought territory.


Importantly, note that in the last week the spread between the 200 and 400-dma collapsed this past week from a near 5-point spread to just a little more than 1-point at Friday's close. This signal will cross next week. Whether or not the "crossing" is the signal of a new cyclical bear market is yet to be seen, but historically it has almost always been the case.


While there are many indicators suggesting more extreme levels of bearishness, which are often the catalysts for at least a short-term push higher in the markets, this has not always been the case. As shown in the chart below, courtesy of Ed Yardeni Research, the bull/bear ratio is now under 1.0 which suggest rather extreme levels of bearishness. Time for the bear market to be over, right? Not so fast.


As you will notice, while in many cases excess bearishness led to rallies during cyclically trending bull markets, during more "bearish" markets, bearishness tended to remain bearish and rallies led to deeper corrections.

However, while bearish sentiment generally provides fuel for shorter term rallies, it is ultimately the underlying fundamentals that provide the sustainability to market direction. As Yardeni also point out, markets tend to follow fundamental underpinnings very closely. If the current downturn in fundamentals continues to build momentum, the markets could be very early in their corrective process.


As I have noted before, bearishness tends to remain a constant companion during cyclical bear markets. As investors are repeatedly molested by ripping bull rallies, and plunging declines, such action keeps markets in oversold territory until the "beatings have improved overall morale."


Yes, this time "could be different."

The Fed could use negative rates, launch another round of QE, or even a combination of the two which would once again push markets higher. However, until such a "Unicorn" appears, we must live in the land of reality and deal with "what is."


Beginning in 2011, I began tracking the Federal Reserve's quarterly economic assessments released after each of the policy-making meetings. Besides the fact they are the absolute worst economic forecasters ever, it was provided to give a sense of transparency into the Fed's actions.


However, following the January policy meeting, there was a very material issue, "no economic outlook." From the NYT:

"The Fed in recent years has issued an assessment of its economic outlook after each meeting of its policy-making committee, but that assessment was missing from the statement after the most recent meeting in January. An official account, published on Wednesday after a standard three-week delay, makes clear that Fed officials simply did not know what to say."

HedgeEye nailed it with this cartoon:


Apparently, if we want an assessment of the domestic and global economy, we need to visit Switzerland and speak with William White, Chairman of the OECD and former Chief Economist for the Bank of International Settlements, to wit:

"The situation is worse than it was in 2007. Our macroeconomic ammunition to fight downturns is essentially all used up.

Debts have continued to build up over the last eight years and they have reached such levels in every part of the world that they have become a potent cause for mischief.

It will become obvious in the next recession that many of these debts will never be serviced or repaid, and this will be uncomfortable for a lot of people who think they own assets that are worth something.

The only question is whether we are able to look reality in the eye and face what is coming in an orderly fashion, or whether it will be disorderly."

And Mr White said the Fed is now in a horrible quandary as it tries to extract itself from QE and right the ship again.

"It is a debt trap. Things are so bad that there is no right answer. If they raise rates it'll be nasty. If they don't raise rates, it just makes matters worse.

It was always dangerous to rely on central banks to sort out a solvency problem when all they can do is tackle liquidity problems. It is a recipe for disorder, and now we are hitting the limit."

And then there is this:

"If policymakers appear defenseless in the face of a fresh threat to the world economy, it is in part because they have so little to show for their past efforts. The balance-sheets of the rich world's main central banks have been pumped up to between 20% and 25% of GDP by the successive bouts of QE with which they have injected money into their economies (see chart 1). The Bank of Japan's assets are a whopping 77% of GDP. Yet inflation has been persistently below the 2% goal that central banks aim for.

In America, Britain and Japan, unemployment has fallen close to pre-crisis levels. But the productivity of those in work has grown at a dismal rate, meaning overall GDP growth has been sluggish. That limits the scope for increases in real wages and in the tax receipts needed to service government debt."

As I have repeatedly discussed in this missive, despite the constant gum-flapping of "nattering nabobs" the economy is no-where near recession, this is only due to the skewing of the data by seasonal adjustments in the short-term. Over the next year as current economic data is negatively revised, the true weakness in the economy will be exposed.

But if you don't believe me, how about a raging bull now turned economic "bear." Joe LaVorgna, in a recent interview, stunned CNBC hosts with a smattering of the truth about what is currently happening beneath the bullish headlines.

Or, how about the same from real estate investing legend Sam Zell, who built the multi-billion dollar empire of Equity Office Properties and sold just prior to the financial crisis.

Okay, see, its not just me. While I have been quite clear that the economic data simply does not support the bullish meme, the trend of prices, deterioration in internal measures and decline in momentum, all suggest that the market has figured out the "game is afoot."

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